Government Intervention Is the Only Black Swan
Back in 2011, prominent hedge fund manager Mark Spitznagel penned for the Wall Street Journal a highly regarded op-ed about excessive government intervention in our limping economy. Spitznagel likened the intervention to wrongheaded efforts throughout history among forest rangers to put out small forest fires.
Small fires are nature's way of forests maintaining their positive evolution, and when firefighters attempt to blunt the minor impact of small ones, they ultimately foster much worse blazes later. Spitznagel expertly, and very correctly correlated firefighting with the hubristic efforts among policymakers to artificially blunt the effects of recession. In doing so he channeled Albert Jay Nock, among many others as will soon become apparent.
As Nock long ago wrote, "Any contravention of natural law, any tampering with the natural order of things, must have its consequences, and the only recourse for escaping them is such as entails worse consequences." Translated, forests are nature as are markets, and if you mess with the natural direction of either, you get much worse down the line.
Many anti-interventionists are asking today what the coming economic forest fire will look like thanks to all the meddling in the markets by our political class, and it says here the fire is already burning brightly. To paraphrase two of Spitznagel's favorite thinkers in Fredric Bastiat and Henry Hazlitt, the seen is an economy limping toward recovery, but the unseen and raging forest fire is what the economy would look like absent all the intervention. Specifically, how many Microsofts and Intels, how many cancer and heart disease cures, and how many transportation innovations have not reached us precisely because our federal minders won't let the proverbial - and rather small - economic fires burn so that an economy comprised of individuals can avoid the big ones?
Thankfully for readers eager to understand why the markets and the economy are both a shadow of what they could be, Spitznagel has written an essential new book. Indeed, The Dao of Capital: Austrian Investing in a Distorted World might be one of the most important books of the year, or any year for that matter.
As evidenced by the book's title, Spitznagel's economics and investing are rooted in the Austrian School tradition of Carl Menger, Eugen von Bohm-Bawerk, Ludwig von Mises whom he deems the greatest economist of them all, along with Bastiat and Hazlitt. Spitznagel rightly notes about Hazlitt that his Economics In One Lesson is the only book he'll ever require his children to read, assuming they reveal no broader interest in the subject. To readers who e-mail this reviewer about books to buy, the response is always that a read of Hazlitt's best known book will have them more informed about how economies work than 99.9% of economists. It's that good, or perhaps economists are that bad. It would be a good debate.
What's initially interesting about the endlessly fascinating The Dao of Capital is that Spitznagel ties the supreme logic underlying the Austrian School with Daoist thinkers 25 centuries before who, "in their concept of reversion saw everything emerging from - and as a result of - its opposite: hard from soft, advancing from retreating." It's rooted in the notion of ‘roundabout' whereby the detour beats the direct route. Whether investing or engaging in direct commerce, Spitznagel notes that the normal, indeed human, route is one of taking the direct, perhaps easy, path to money, commercial success, or both.
Spitznagel very entertainingly uses commercial and military history to disprove the ‘easy' as the correct path. He makes plain throughout that the most successful investors and businessmen take the indirect road; essentially going right in order to ultimately go left. Of course, to achieve roundabout success one must be willing to underperform in the near, and sometimes long-term in order to ultimately come out ahead.
Spitznagel initially learned his philosophy at the Chicago Board of Trade (CBOT) from his mentor, grain trader Everett Klipp. Though Klipp was neither a Daoist nor an Austrian, his investment style encompassed the teachings of both. And it was highly counterintuitive.
As Klipp made plain, "Any time you can take a loss, do it, and you will always be at the Chicago Board of Trade." The problem by Klipp's estimation was that too many smart people who understood the market were possessed by an "urgency for immediate profits." Their elevation of near-term profits ultimately rendered them unfit for successful tenures at the CBOT. As Klipp sermonized to Spitznagel, "One trade can ruin your day. One trade can ruin your week. One trade can ruin your month. One trade can ruin your year. One trade can ruin your career."
In light of the above, the smart market player should stand back and let the all-too-human traders rush in for the quick profits. As Mises put it, "once a boom sets in, a bust is inevitable." Much as conifers in forests "take root in the out-of-the-way places, rocky and inhospitable, where few can survive," only to re-seed in the more hospitable parts of the forest after the small fires clear the land, so must successful investors wait patiently, far from the frenzy, only to aggressively return - cash in hand - for the bust that is authored by the boom.
Spitznagel notes that "I earn my living from the hungriness of investors" for immediacy. He waits patiently and zigs left so that he can eventually turn right. It all seems so easy, but then it's not human nature for most to stay sidelined as easy investing profits reveal themselves.
Put plainly, and going back to Daoist thinking in a book that teaches us how to think, our nature is to pursue the li strategy of immediacy, over the shi of patience and non-aggression. Most are incapable of the latter.
Of course shi is underlay by Austrian School thinking, not to mention the writings of 19th centur French political economist Bastiat. It once again centers on the seen vs. the unseen. It's of extreme importance to the twins that are economic and stock market health.
And just as some, but not all, investors seek profit immediacy when they commit capital, politicians similarly lust for li when they impose their policy visions on the electorate. For background, we must consider the broken windows fallacy first described by Bastiat, and later by Hazlitt. The Paul Krugman view is that if a businessman's window is broken then the economy benefits. That's the case because the owner of the business will have to hire a glazier to replace the window, and then the glazier, newly flush with cash for having fixed the window, buys shoes, thus stimulating the cobbler. That's the seen. But to Austrian thinkers the "key is to free oneself from a tyranny of first consequences, overvaluing what comes first at the expense of what inevitably comes later."
Austrian thinkers correctly look ahead to the ‘unseen,' as in if the initial business owner hadn't had to pay for a broken window, he could have invested in a new hire who might expand the productivity of his business, he might have expanded into a new product line, or perhaps expended his always limited capital on signage meant to make his business more attractive to the passerby.
Von Mises perhaps put it best in his classic book Liberalism in which he properly observed about war that it "only destroys; it cannot create." To Keynesians of the Krugman variety, war is stimulative because existing capital is immediately put to work creating weaponry, and all manner of goods necessary to stage a fighting force. More on this later, but the seen is war mobilization putting the jobless to work on the way to ‘growth' as measured by the horrid GDP calculation worshipped by Keynesians, and sadly too many others not part of the delusional Keynesian camp.
Austrians naturally look beyond the initial result of policy, noting that war machines are created to kill potential customers, and thus must shrink the economy in short order. Quoting von Mises once again, "war destroys the division of labor inasmuch as it compels each group to content itself with the labor of its own adherents." It's horrifyingly asserted to this day that WWII ended the Great Depression, but in truth, it set the U.S. back immeasurably. War destroys wealth that must be rebuilt, as opposed to building on existing wealth, plus it retards the division of labor that happily brings all labor force participants more and more toward the very work specialization that boosts their productivity, increases their wages for productivity serving as a lure to investment, and then expands the range of goods they can access.
Looked at in a more broad sense, hapless politicians seek the immediacy of taxing and borrowing from the private sector in order to use the funds to create jobs, but their desperate search for quick cures means that their taxing and spending soon enough starves the real economy of investment necessary to expand. Looked at in today's terms, the looming fire isn't deficits that ‘someday' (it's always someday) will prove insurmountable, rather it's the here and now whereby nosebleed government spending deprives entrepreneurs of seed capital, and workers of wages.
Addressed in terms of money, the ‘seen' that so captivates Keynesians and the political class is the rabid consumption that will in the near-term result from currency devaluation, but the unseen is the investment, productivity, and resulting wage growth that will be stunted for the needs of savers - society's ultimate benefactors to paraphrase Adam Smith - being dismissed. The same applies to interest rates. It's fun to think that central bankers can make credit cheap, but the latter is the equivalent of rent control with apartments. The ‘seen' is cheaper apartment rent, but the longer-term ‘unseen' is apartment scarcity for the builders of same being deprived of market-driven rent. Spitznagel comically references George W. Bush's cruel blessing in the form of Ben Bernanke as the "head ‘ranger'" constantly seeking to put out small fires with quantitative easing (QE) and interest rate machinations, but the unseen is the credit scarcity that results from adolescent attempts to make it cheap.
Applying the Austrian view to investing itself, Spitznagel happily elevates the great Henry Ford. To the author, Ford was most certainly an Austrian even if like Klipp, he wasn't a reader of Austrian School books. As Spitznagel writes, "If it were within my power to go back in time to arrange a meeting, it would surely be between Ford, Bohm-Bawerk, and Mises, whose lives overlapped." Absolutely!
In Spitznagel's eyes, Ford was "the embodiment of the roundabout entrepreneur who created a new paradigm of production." Figure cars were ‘space age' before the latter became a phrase, but rather than seek the immediacy of easy profits, Ford held back, constantly reinvesting profits earned. As Spitznagel writes, "Ford Motor Company would not have prospered had the founder not committed to continuous long-term investment in improvements and roundabout production."
Notably, the Ford example explains why "value investing" is really only an "estranged brood" of Austrian investing per the author. Austrian investors don't so much look for the cheap and sometimes prosaic as much as they look for companies run by entrepreneurs willing to delay immediate profits in favor of constant re-investment in the production process such that they ultimately thrive. Ford's disciplined reinvestment in the assembly line was a left turn, a detour as it were, that eventuated in a right turn, and a car production process that could be measured in seconds. To put it more simply, Ford pursued the shi strategy on the way to great fortune.
Considering Ford's genius in an economic sense, and it's really hard to separate the economic from the market, Spitznagel writes that "the advantages and gains that are realized today are due to capital that was invested previously." This is so true, and arguably the most succinct refutation of Keynesianism in print today. Keynesianism is about consuming - and really wasting - available capital today at the certain expense of long-term economic advancement tomorrow. This most absurd of ideologies has sadly been revived in modern times, and since it has been, it's no surprise that the economy limps along.
Taking the investment process further, Spitznagel writes that the "Austrian investor doesn't lunge in li fashion immediately for the goal," rather the Austrian searches for "highly roundabout, productive firms - ones with high ROIC - that possess the circuitous means of economic profit." Going back to Spitznagel's mentor in Everett Klipp, Klipp's Paradox is one of "love to lose money, hate to make money," or better yet, Austrian investing "is not to find a way to make money now, but to position ourselves for better investment opportunities later" when the von Misean "crack-boom" forces impatient li investors into sell mode. It's then that the shi investor, the human conifer as it were, "can be strategically impatient" in more cheaply purchasing companies that were patient about creating a profitable business model.
Are Austrian investors searching for the "black swans" or "tail events" that consume so much of the thinking of the average investor? The answer is no. As Spitznagel puts it, "When it comes to market events, there have been no impactful black swans." To the Austrian investor a "black swan" is an asteroid hitting the earth. Regarding big market events, Spitznagel writes that the "stock market plunges that have occurred over the past century most certainly were not black swans or tail events." In truth, they were entirely predictable events made that way by policy error that eventually led to crack-ups. Let's perhaps call government itself our black swan. The Austrian investor waits for corrections made inevitable by government error, and is once again conifer like in aggressively returning to the land cleared out by the small forest fire in search of companies that patiently and wisely invested their capital.
Austrian economic and market thinkers essentially analyze government policies for distortive errors, and specifically avoid what they deem policy-driven bouts of li that will surely end in tears. Spitznagel is understandably reverent toward von Mises, and notes that when the great Austrian economist was offered a position at Austria's Kreditanstalt Bank in the late ‘20s, he demurred given his belief that a crash was on the way. Von Mises was proven correct about what was ahead, and Spitznagel writes about the best and most famous of the Austrian School scholars that von Mises was "the man who predicted the Great Depression."
About the above, it's the best guess of this reviewer that Spitznagel simply worded what he meant improperly. As he would know better than most, and as he writes throughout The Dao of Capital, market and economic corrections are healthy, economy-enhancing fires that, if left alone, clear out all the waste, misuses of labor, and Austrian-defined malinvestment that previously took place. What it seems Spitznagel means is that von Mises foresaw the crack-up itself.
Indeed, for von Mises to have predicted the Great Depression, he would have had to have predicted an economy-sapping reversal of the global division of labor in the form of the Smoot-Hawley tariff, a rise in the top U.S. tax rate from 25 to 83%, an enormous increase in economy-suffocating government spending, a devaluation of the dollar, wage floors, and the imposition of a Undistributed Profits Tax of 74% on retained corporate earnings. Returning to Ford Motor Company, Spitznagel's previous assertion about how it came to be great is apt in this regard. Would Ford have become the global brand it ultimately ascended to if such a tax had been in place in the early part of the 20th century? It's hard to imagine, at which point it should be said that von Mises predicted a crash, as opposed to a multi-year debacle solely authored by politicians naively trying to put out small economic fires that Austrians would logically deem healthy, and prefer be left alone.
Moving to the 1920s that preceded the Great Depression, Spitznagel asserts that the boom was monetary in nature. He acknowledges very clearly that the latter is much debated to this day, though modern Austrian thinkers in particular tend to be of the view that excess credit created by the somewhat newly formed Federal Reserve ignited what was seemingly an artificial expansion. The latter isn't compelling to this reviewer.
Indeed, the ‘20s began with a massive recession, one much worse than that which revealed itself in 1929-30. The difference, and this is why we rarely hear about the early '20s downturn, has to do with the federal government's response. Quite unlike the hubristic actions taken by the political class in the ‘30s, government spending was cut in half, the top tax rate trended downward all the way down to 25%, and at least until the mid ‘20s, the integrity of the dollar was maintained.
Austrian thinkers question the credit boom in the ‘20s, but to paraphrase John Stuart Mill, when entrepreneurs are producing in productive ways, they are explicitly demanding money. In light of the pro-growth policies that prevailed in the ‘20s, and particularly in light of the fact that growth engine England kept its tax rate at WWI confiscatory levels, is it any wonder that a boom ensued in the U.S. as credit flowed to the world's foremost growth story? Just the same, is it any wonder that as productivity ramped up that dollars in circulation and credit soared alongside all the activity?
It's said that money was easy then, but then the best forward signal of easy money is commodity prices, yet there's no evidence that they were rising. This is very contrary to Austrian theory, but commodities prices from the mid ‘20s onward suggest overly tight money. In The Forgotten Man, economic historian Amity Shlaes observed that in the late 1920s, farmers suffered "falling grain prices." In their book Monetary Policy, A Market Price Approach, economists Manuel Johnson and Robert Keleher noted that from 1921 to 1930, "prices actually fell 1.1 percent per year." It should be stressed here that in a capitalist economy prices are always falling as productivity enhancements - per von Mises - make today's luxuries tomorrow's necessities. Still, the price level with stable money value would be flat for falling prices creating new demands for other goods previously out of reach. Further on in Monetary Policy, Johnson and Keleher discussed the Fed, and the fact that "it disowned any responsibility for the drastic decline of commodity prices which had been underway since 1925."
Perfect money in the Ricardian or Smith sense is that which doesn't change in value such that it serves as a measuring rod that facilitates exchange of consumable goods and investment. More to the point, if a weak dollar is problematic for fostering malinvestment, then so must a rising dollar similarly be problematic for corrupting prices such that malinvestment creates a deflationary style crack-boom.
Looking at the stock market crash from this perspective, Liaquat Ahamed noted in The Lords of Finance that when the stock market topped out in September of 1929, "only 19 of the 826 stocks on the New York Exchange attained all-time highs. Almost a third had fallen at least 20 percent from their highest points." It's surely another way of looking at the ‘20s, but Ahamed's numbers suggest that the correction began long before the historically significant 12.5% crash in October of that year, and it's at least arguable that tight, as opposed to easy money, loomed large in bringing about the eventual market reversal.
Spitznagel notes that von Mises referred to the "artificial expansion of bank credit" when discussing "the perverse effect of inflation," but just the same, von Mises in The Theory of Money and Credit described inflation as "an increase in the quantity of money, that is not offset by a corresponding increase in the need for money." By the latter definition, and taking into account the Fed's fear of gold inflows in the ‘20s such that it didn't create commensurate money, one could at least posit that the Fed oversaw a deflationary event in the classical sense such that dollar demand outweighed supply on the way to a rising unit of account.
All of the above is very debatable, Spitznagel acknowledges as much, but Smoot-Hawley was initially conceived (wrongly) as relief for farmers suffering falling agricultural prices. It's speculation, but assuming the dollar's integrity is fully maintained in the ‘20s, it can at least be suggested that there's no major crash (the 12.5% correction occurred alongside word that President Hoover would sign Smoot-Hawley in 1930) thanks to a stable dollar fostering a more rational distribution of investment, not to mention making the horrors of Smoot-Hawley less likely.
Moving far ahead to the more recent crack-up, what's undeniable is that a rush into the consumption of housing was not just recessionary for real economic ideas suffering a lack of investment at the expense of consumption, but that the latter was a prime example of what Austrians once again refer to as malinvestment. What reads as potentially wanting is the notion that it was driven by excess credit through artificially low interest rates.
No doubt rates were artificially low, but then just as government-enforced apartment rents lead to scarcity of same, so logically would artificially low rates of interest at least somewhat mitigate naïve central bank efforts to create massive amounts of credit. Figure in the 1970s the Fed was rapidly hiking interest rates, but George Gilder described the Carter-era housing boom this way in his early ‘80s classic, Wealth and Poverty:
"What happened was that citizens speculated on their homes. ... Not only did their houses tend to rise in value about 20 percent faster than the price index, but with their small equity exposure they could gain higher percentage returns than all but the most phenomenally lucky shareholders."
Gilder's description of the ‘70s begs the question of what truly drives what von Mises described in Human Action as a "flight to the real." Does easy credit author housing booms, or does credit simply flow to the assets least vulnerable to monetary error? Comparing the ‘00s to the ‘70s, rates were falling during the ‘00s, they were rising during the ‘70s, but the one constant of the two periods was a falling dollar as measured in gold. With it once again undeniable that policy error fostered a recessionary housing boom, it's arguable that the falling dollar trumped low rates as the driver of that which ended in tears. Absent a declining unit of account that aided commodities priced in dollars, and that surely made hard assets like housing more attractive, it's not unrealistic to assume that no major, economy-sapping housing boom reveals itself.
Some would argue that low rates beget a weak dollar, but then in the ‘60s interest rates were very low alongside a not perfect, but largely stable Bretton Woods dollar. Japan's yen soared against the dollar and gold in the ‘80s and ‘90s despite lower rates across the yield curve. And then it should be noted that the housing boom was global despite higher rates of interest around the world. The latter occurred alongside broad currency weakness versus gold given the sad, and highly unnecessary tautology that when the dollar is falling, it's always and everywhere a global event for all currencies.
The above digression is in no way meant to detract from the essential economic and market story in The Dao of Capital. Just as artificially low rates of interest clamored for by politicians and imposed by central bankers in search of li are evidence of policy error, so are policies of currency weakness evidence of li yearnings among politicians and central bankers. The seen is the near-term boom in assets least vulnerable to devaluation, not to mention heavy consumption, but the unseen is the investment that never occurs as li seeking investors migrate toward the immediacy of profits in hard wealth that already exists; the latter at the expense of shi investment in the stock and bond income streams representing wealth that doesn't yet exist.
More sad here is that while government calculations promote the idea that Americans don't save, the stupendous wealth in this country is a certain signal that Americans, particularly when government policy is mostly good (the ‘20s, and then ‘80s and ‘90s when the dollar was revived, taxes fell, trade was opened, and deregulation occurred with greater speed), save with great gusto. Simply put, if we weren't savers, we wouldn't be so wealthy.
Applying the above to Wall Street, though it's seen as short-term in nature, investment banks have proven rather patient as evidenced by their investment in pharmaceutical companies, to name but one sector. Looking at the proliferation of global brands created on these shores such as Apple, Microsoft and Procter & Gamble, it seems Americans too are ‘roundabout' in the way they build great companies. Americans are in a very real sense Austrian by nature.
The problem ultimately comes down to economists and the politicians so eagerly in their thrall; both classes infected with the immediacy of li. Spitznagel throughout The Dao of Capital mocks the non-science that is economics for cruelly plunging the U.S. and the world into "repeated financial crisis and labor market stagnation." Desperate to be relevant in a world that would advance and thrive much more powerfully without them, economists and politicians continue in their adolescent attempts to put out the small fires that the economy desperately needs so that it can truly grow. But since they can only conceive the seen, the global economy is as a result suffering a raging blaze.
In that case, thank goodness for Mark Spitznagel's tour de force, a book that will hopefully be widely read by all. Economics isn't about numbers, it's about human action, it's about people failing and succeeding, and constantly fixing errors with growth the natural result assuming governments get out of the way. The Dao of Capital explains in dazzling fashion that growth is ours for the taking, but it will only reassert itself if our minders in government allow nature to take its course such that failure, recessions, and market corrections are viewed every bit as positively as success, economic booms, and bull markets.