## Tuesday, August 25, 2015 ... /////

### Western stocks saved? People with lots of cash may be lucky

Except for Shanghai which dropped again, the world markets seem to compensate and, in Europe, overcompensate the yesterday's collapse. For example, the Prague index was adding almost 4% before the Bank of China announced that they would lower the rates from 4.85% to 4.60% (and relax the reserve requirements for banks) – and that added another percent, e.g. to almost 5% in Prague, across Europe.

It's amazing what such a relatively small move by an exotic nation can do. If you assumed proportionality, zero rate interest policy in China would add 18% to the stock indices.

Tony believes (or believed yesterday) that there would be many false rebounds – upticks followed by bigger drops – and this dynamics will be driven by clever institutions who want to attract buyers and sell them their big portfolios. I may be an optimist (not quite a perfect optimist: I sold about 10% of my stocks in a moderate wave of panic yesterday, the worst day to sell so far) but I find it a bit more likely than not that the Monday closing price was the bottom for a long time.

In particular, I don't believe Tony's suggestion that the institutions are "in charge of the things" and capable of systematically fooling and robbing smaller investors. The institutions also fight against each other. And they have lots of disadvantages. For example, if you want to sell or buy too many stocks at the same moment, you are driving the price in the unfavorable direction.

Moreover, the mass of the individual investors does matter and it is largely unpredictable.

One question is the mood of the old investors who mostly thought that capitalism could be dying as recently as last night. You know, it's nonsense. Capitalism has been around for centuries and it just works and grows and will continue to do so. But we're not quite sure that it's nonsense, right? The certainty gets reduced when you witness a bloody massacre on the markets.

But there are other people, the new investors. After a recent big downturn, the stocks were systematically growing for 4 and, basically, for 6 years now. Many people with tons of cash could have thought for years that it was a bad moment to enter stocks. They must have been overpriced because they avoided any drops for years. Well, this argument isn't really rigorous but many people have thought in this way, I am convinced.

They had – and still have – the opportunity to buy into stocks with some 10+ percent discount. And one may also buy things like Chinese stocks with a 30% discount. One isn't guaranteed anything but these days are surely a better moment to enter the stock market than e.g. Spring 2015. If you've never owned stocks and you're thinking about it now, you're not guaranteed to win big bucks by Christmas 2016, for example, but you're guaranteed to have a better return than those who joined in the spring. You may easily calculate the difference.

Krugman claims that this instability – repeated in various variables – is ultimately due to the too small number of investment opportunities for the large amount of savings people want to park. Well, maybe, it may be a part of the truth. However, I think that instabilities are possible if there are too many opportunities, too.

I think that the future global monetary and economic system – and national economic systems – should be reengineered to eliminate most of the "useless" volatility. What do I mean?

The markets are great in determining the right prices, exchange rates, interest rates etc. that optimize the allocation of resources, labor, and lots of other things, that allow the people to have as much as possible for the money they earn etc. But an important point of mine – which seems generally ignored – is that the values of some of these variables (or their linear or other combinations or other functions) are more important or much more important for the effectiveness of the system than others.

The price ratio of two products – or materials etc. – that directly compete with each other is extremely important for the effectiveness. You often need to know this price ratio with a 1-percent or better accuracy because the product or material is often "absolutely needed" and the price difference may directly translate to the price of your products or the money you still have after you buy something.

On the other hand, the "absolute numbers" – and many of the ratios of prices of things that are decoupled, totally different in character, or have nothing to do with each other – are less important for the efficiency. These are also the numbers that tend to fluctuate wildly and those wild fluctuations act both as a mandatory lottery for all the people; and as a destabilizing force for the economy.

Obviously, the overall value of a currency unit is a pure convention. But even the inflation rate is "pure gauge" as long as it is sufficiently safely positive. You may rescale the value of a currency-unit in a time-dependent way and the physics (economics) may be exactly the same. I hope that this "gauge theory of economics" is appreciated by the TRF readers.

However, I am talking about variables such as

1. most exchange rates oscillating at an annual time scale
2. overall stock indices – ratio of the value of cash vs means of production
3. most of the price ratios relating industries and parts of the economy or asset classes that are "very far from each other"
These variables are no longer "pure gauge". They have a physical meaning. They regulate some things but only very slowly. These variables are highly volatile exactly because there's no straightforward operational procedure that would determine their "optimum or fair value". That's why it's so easy for the traders to surrender to mass hysteria and drive these variables very far in one direction or another.

Examples. What are we talking about? Some exchange rates are much more fluctuating than what's needed for "anybody". For example, 1 euro may be $1.44 but it may drop below$1.05 in half a year. Does it have some reason? Is there a value to calculate a right or "sustainable" rate with a better accuracy? The point is that the world – and both continents – will pretty much work for any value of this exchange rate, within a rather broad range.

A stronger euro may hurt the European exports but the dependence is rather limited. Moreover, there isn't any reason why the trade balance should be exactly balanced. There may be various justifications why the trade balance of a nation should be nonzero. It may be hoping to invest right now and repay in the future. It may have trade deficits because it can afford them due to its currency which is the main world reserve currency. A currency may be weakened because the nation (or group of nations) using it may be perceived as a threatened one. A nation like China may need a weaker currency to preserve trade surpluses because exports are the main driver of its growth and it just wants or deserves a higher growth rate than others, and so on.

(Imagine that a large human colony on Mars would have its own currency and think how difficult it would be to translate it to the U.S. dollars. The trade between the Earth and Mars is so difficult – and the issues that are important for life on the two planets are so different and incomparable – that the mechanisms trying to enforce the "right exchange rate" of the Mars koruna and the U.S. dollar are insanely weak. Such an exchange rate could easily oscillate by an order of magnitude every year.)

So exchange rates like EURUSD may fluctuate wildly. I don't think that these wiggles are so wonderful. Many people talk about the healthy role of the fluctuating exchange rates for the curing of the imbalances of a given nation. (Southern European nations are often said to be better off with their own, quickly devaluing currencies.) But I think it's obvious that most of the fluctuations of similar exchange rates don't play any useful role of this kind.

Similarly, the stock indices. Again, it's obvious that you want to have some idea about the price ratio of the Burger King and McDonald's because they directly compete. But what about the stock indices?

Dollar millionaires store about 1/2 of their liquid wealth in cash, bonds, and related things; and 1/2 in stocks. They may have different percentages. But to the zeroth approximation, we may say that a growing stock market means that the wealth is being redistributed from the cash-long millionaires to the stock-rich ones; the motion goes in the opposite direction when the stock indices go down.

But do these swings play any useful role? If one of the two groups of millionaires benefits, is it being rewarded for something it did well? At least some good useful prediction? Is the other group punished for some bad sin or mistake? I don't think so. After all, most of these variables – like the stock market indices – are being mostly regulated by the interventions by the central banks etc.

This fact isn't a proof of the terrible disappearance of capitalism and the increasing power of central regulation, I think. It seems totally inevitable to me that such softly relevant – hard to measure, in the markets – variables are being driven by some central interventions if not arbitrary social conventions. To a large extent, it's true even e.g. for the ratio of stock prices and real estate, and even for the price ratios of stocks of one kind (utility) and another kind (financials).

So I think that the world economy would be more efficient if most of the volatility in these variables were suppressed. I do think that at the end, some global currency – a modern version of "gold" – would be better. I can imagine that instead of national currencies, people in the whole world could be paid in "special currency units" that are optimized for sectors of the economy, if needed.

At the end, some rebalancing is needed for these variables. But in most cases, there's no reason for a big hurry. If the system waits for half a year or more, it usually doesn't matter. So if some mechanisms were imposed to increase the inertia in all these variables, it wouldn't hurt: it would help.

Take the eurodollar as a trivial example. The euro was worth less than $0.85 at some moment in 2001 but around$1.60 in 2008. It almost doubled. Was there any good reason why it was so? The central banks (ECB, Fed) could simply agree to partially stabilize this exchange rate and buy/sell the euros and dollars so that a fraction of the day-to-day and week-on-week and year-on-year swings is eliminated. It wouldn't hurt anything; if one of the currencies really needed to weaken, it would eventually weaken, anyway. But the historical range could have been reduced from $0.85-$1.60 to $1.05-$1.40.

Similarly, the stock market indices may be "partially targeted". It means that there would be some "healthy expected" growth rate, like 12% a year, and the central bank would use this as one of the guides – along with things like inflation targeting – in decisions about the interest rates (and perhaps some unorthodox policies if there were any). Some of the decisions could be made automatic or objectively calculable.

With stabilizing policies like that, if they implied e.g. the reduction of Dow Jones' swings, the Great Depression of the 1930s could have become a minor recession or nothing exceptional at all. At the end, I do think that the central banks etc. are afraid of certain big changes in numerous variables and that leads them to make certain decisions that must be explained by something else, however. I think that a list of these "instabilities to fight against" should be made explicit and the system should simply be stabilized like that.

If violent "useless fluctuations" in many of these variables were heavily reduced, it would make the money, stocks, and many other things more predictable – which is a good thing for the same reason why it's usually a good idea to list the price of something with the accuracy of 1% or better.