Busy at Work But Paying Attention to This
We pick up where we left off last time with Aftermath by James Rickards. It's the fourth of series of book by Rickards. I've read two of the previous three, and just finished Aftermath. I've recommended it to others. It's a worthwhile read to get you ready for what the coming recession may bring.
Rickards' background includes work in investment management and government consulting. He's in demand as a speaker. I find his writing to be clear. I like his thought process. You don't have to agree with everything he says, but if you pay attention you'll learn a lot.
One of the key things you'll learn: complexity theory. Rickards thinks it helps illustrate and explain what he sees as meaningful threats to financial markets and our economy. Here's a definition: the study of complex and chaotic systems and how order, pattern, and structure can arise from them. The theory asserts that processes having a large number of seemingly independent agents can spontaneously order themselves into a coherent system.
Rickards seems to be a big proponent of looking at the world through the lens of complexity theory. Read the book and you'll see why. It makes sense. But without trying to capture here what's in the book, most of us can likely find examples of complexity theory in our own lives. Family life alone brims with them, especially if you have kids. Each child, being an individual, has their own set of behaviors and emotions, all of which interact with other members of the family. Think about it: Can you imagine anything more complex? Add in the individual personalities of Mom and Dad. Ever noticed how one person's bad mood can quickly spread. Or maybe the opposite as well: A cheerful, upbeat start to the day by even one family member can lift everyone's spirits.
Now, I'm not sure that's a perfect example of complexity theory, but it does get the point across that everyone effects everyone else. Translating to financial markets and the economy, you might start with the understanding that everything effects everything else. Seems sort of obvious when you put it that way. I think most people would agree in the general sense. But when it comes to specifics, somehow this gets lost.
For example, in financial markets, people tend to focus on their own situation, rather than the impact their decisions might have on markets in general. And that's only natural. I'm not thinking of how my decision to buy or sell a stock might effect the broader market. Even if it does, it's impact will likely be infinitesmal - most of the time. But, hard as it might be to conceive, there might be a time when my decision to buy or sell a stock will trigger an avalanche of buying or selling.
Indeed, the phenomenon of an "avalanche" is used to illustrate this aspect of complexity theory. We're all familiar with and avalanche as an event that occurs when a cohesive slab of snow lying upon a weaker layer of snow fractures and slides down a steep slope. Complexity theory would note that the snow was in a critical state prior to the avalanche, here the cohesive slab lying on the weaker layer. Thus even a single snow flake could tip the balance and cause the avalanche to begin.
Applied to markets, complexity theory would attempt to identify whether a market was in a critical state that could trigger a violent response. While markets can jump up violently, we're usually more concerned with, and therefore focus more on, the possiblity that they can fall violently - i.e., crash.
Rickards asserts that the stock and bond markets exhibit characteristics of a critical state. Ditto for the world's major economies.
The chief trait that causes him to think financial markets are in a critical state is the amount of leverage in the system. Hedge funds, for example, borrow money to buy stocks and bonds. They do this because, when conditions are ripe, they can exponentially increase their returns by using borrowed money. Because short-term rates were essentially held to zero after the 2008 crisis, borrowing costs were minimal, enticing aggressive players to borrow aggressively.
But those low interest rates also spurred borrowing in other sectors of the economy besides financial services. Corporations borrowed heavily. Much of that borrowing did not go into productive enterprise. It was used to buy back the company's own stock, thereby pushing up the price of the stock. Since major components of the S&P 500 pursued this stock buy-back strategy, stock prices advanced more aggressively over and above the impetus provided by institutions and hedge funds that borrowed to buy stocks.
More sectors of the economy were blown up by those low interest rates. But the biggest borrower has been the government. Total federal debt has increased to record levels. The budget deficit (difference between money coming in and money being spent by the federal goverment) has increased dramatically, further adding to the total debt. State and local borrowing has continued to grow to record levels.
Now add to this future, or contingent, liabilities to federal and state government. A few quick examples: The states have pension obligations they likely won't be able to meet. The federal government has social security and medicare payments that will soon exceed their sources of revenue.
We're looking at a massive debt bubble in both the public and private sectors that Rickards sees as that top layer of snow just waiting to be dislodged. What will be the consequences when it finally breaks loose? That's what Afermath tries to sort out.
As we go to work each day, minding our own business, it's perfectly understandable if we're not focused on the avalanche that hasn't happened yet. But do we really want to totally ignore it?
More next time.
Rickards' background includes work in investment management and government consulting. He's in demand as a speaker. I find his writing to be clear. I like his thought process. You don't have to agree with everything he says, but if you pay attention you'll learn a lot.
One of the key things you'll learn: complexity theory. Rickards thinks it helps illustrate and explain what he sees as meaningful threats to financial markets and our economy. Here's a definition: the study of complex and chaotic systems and how order, pattern, and structure can arise from them. The theory asserts that processes having a large number of seemingly independent agents can spontaneously order themselves into a coherent system.
Rickards seems to be a big proponent of looking at the world through the lens of complexity theory. Read the book and you'll see why. It makes sense. But without trying to capture here what's in the book, most of us can likely find examples of complexity theory in our own lives. Family life alone brims with them, especially if you have kids. Each child, being an individual, has their own set of behaviors and emotions, all of which interact with other members of the family. Think about it: Can you imagine anything more complex? Add in the individual personalities of Mom and Dad. Ever noticed how one person's bad mood can quickly spread. Or maybe the opposite as well: A cheerful, upbeat start to the day by even one family member can lift everyone's spirits.
Now, I'm not sure that's a perfect example of complexity theory, but it does get the point across that everyone effects everyone else. Translating to financial markets and the economy, you might start with the understanding that everything effects everything else. Seems sort of obvious when you put it that way. I think most people would agree in the general sense. But when it comes to specifics, somehow this gets lost.
For example, in financial markets, people tend to focus on their own situation, rather than the impact their decisions might have on markets in general. And that's only natural. I'm not thinking of how my decision to buy or sell a stock might effect the broader market. Even if it does, it's impact will likely be infinitesmal - most of the time. But, hard as it might be to conceive, there might be a time when my decision to buy or sell a stock will trigger an avalanche of buying or selling.
Indeed, the phenomenon of an "avalanche" is used to illustrate this aspect of complexity theory. We're all familiar with and avalanche as an event that occurs when a cohesive slab of snow lying upon a weaker layer of snow fractures and slides down a steep slope. Complexity theory would note that the snow was in a critical state prior to the avalanche, here the cohesive slab lying on the weaker layer. Thus even a single snow flake could tip the balance and cause the avalanche to begin.
Applied to markets, complexity theory would attempt to identify whether a market was in a critical state that could trigger a violent response. While markets can jump up violently, we're usually more concerned with, and therefore focus more on, the possiblity that they can fall violently - i.e., crash.
Rickards asserts that the stock and bond markets exhibit characteristics of a critical state. Ditto for the world's major economies.
The chief trait that causes him to think financial markets are in a critical state is the amount of leverage in the system. Hedge funds, for example, borrow money to buy stocks and bonds. They do this because, when conditions are ripe, they can exponentially increase their returns by using borrowed money. Because short-term rates were essentially held to zero after the 2008 crisis, borrowing costs were minimal, enticing aggressive players to borrow aggressively.
But those low interest rates also spurred borrowing in other sectors of the economy besides financial services. Corporations borrowed heavily. Much of that borrowing did not go into productive enterprise. It was used to buy back the company's own stock, thereby pushing up the price of the stock. Since major components of the S&P 500 pursued this stock buy-back strategy, stock prices advanced more aggressively over and above the impetus provided by institutions and hedge funds that borrowed to buy stocks.
More sectors of the economy were blown up by those low interest rates. But the biggest borrower has been the government. Total federal debt has increased to record levels. The budget deficit (difference between money coming in and money being spent by the federal goverment) has increased dramatically, further adding to the total debt. State and local borrowing has continued to grow to record levels.
Now add to this future, or contingent, liabilities to federal and state government. A few quick examples: The states have pension obligations they likely won't be able to meet. The federal government has social security and medicare payments that will soon exceed their sources of revenue.
We're looking at a massive debt bubble in both the public and private sectors that Rickards sees as that top layer of snow just waiting to be dislodged. What will be the consequences when it finally breaks loose? That's what Afermath tries to sort out.
As we go to work each day, minding our own business, it's perfectly understandable if we're not focused on the avalanche that hasn't happened yet. But do we really want to totally ignore it?
More next time.
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