Thursday, April 14, 2016

There can't be any bursting, ZIRP-driven "bubble in everything"

Even though I am not really interested in the money too much, I would probably agree that Peter Thiel is a role model of mine. He is an unusually intelligent venture capitalist. He's co-founded important companies like PayPal, made the right investments such as the first big cash injection to Facebook, and has done real work in hedge funds since 2002, Clarium and Founders Fund.

He has always (well, a few times) beat in me in chess and I think that he always will.

He's considered a contrarian investor whose beliefs often differ from the overwhelming majority by 180° and if he makes a loss, it's because he's too brilliant. I have tons of understanding for the smart people who sometimes differ by 180°, you surely believe me. But I still think that his
100-second Bloomberg interview about the "bubble in everything" (hat tip: Willie Soon)
isn't just contrarian, it's irrational. Thiel has expressed some thoughts about the financial markets that we actually hear quite often but they contradict the thoughts and interpretations by mainstream professional bankers such as Super Mario Draghi or Janet Yellen. I am absolutely convinced that Draghi and pals understand what's actually going on with these variables much more than Thiel and others (including the constantly crash-predicting folks via Newsmax and Donald Trump with his promises of collapsed bubbles within 2 months).

Meanwhile, in the real world, the U.S. unemployment dropped to the lowest level since my birth, a detail that none of the doomsayers bothered to predict.

Thiel said that he saw no bubble specifically in the tech sector. It's an attitude he has expressed many times before, and I agree with that – also because the technological stocks' prices haven't even surpassed the prices before the 2000 crash yet – a reason why we might say that we're still in some kind of a long-term bear market since 2000.

But otherwise, we were told that quantitative easing and near-zero interest rates have created a "peculiar bubble in nearly everything". Thiel also said:
Startup tech stocks may be overvalued, but so are public equities, so are houses, so are government bonds. Silicon Valley is quite far from it. If the bubble is in cash, illiquid startup investments may be a place to hide.
What? :-)

What is it exactly supposed to mean that there is a "bubble in everything"? The set of prices contains some information but it's really just some "relative prices" that make a physical sense. If you study atomic and molecular physics, you may talk about the size of many atoms or molecules. Those are ten to minus ten meters etc. and you may keep on repeating: the sizes are so small. But at some moment, you should calibrate your expectations or choose sensible units (1 angstrom, for example), and everything is normal.

Prices may also be "absolute" prices, but that's just a different word for the relative price of something and the U.S. dollar (or the currency in which the asset is normally denominated). The value still depends on the choice of the benchmark in the denominator.

Now, imagine that you locate all "positive" assets in the world that belong to someone and that are liquid enough to be sold within 1 month or less, assuming that the world won't be totally different than it is now in one month. Fine. You get a few hundred trillion of dollars. The amount may also be translated to the euros according to the current exchange rate, or something like that; I make the comment to point out that there is nothing "qualitatively" special about the U.S. dollar. Let's subtract all the debt that individuals have, and eliminate all people who end up below zero (in red numbers).

If you have decided which assets have made it to the list, and who are the "positive worth people", you can just express their wealth as a percentage of T, the total value of the world (its owned part) which is several hundred trillion dollars. The average person on Earth or its orbit (including those with a net debt) owns 0.14 parts per billion of T simply because there are 7+ billion people. Almost all TRF readers own more than that, at least by an order of magnitude.

Now, when the markets evolve and fluctuate, your percentage of T is changing. But the sum of all the percentages is always 100 percent – the total positive worth is T. It's true by definition. With this attitude, all changes of the wealth or the value of a portfolio are relative. Someone gets richer, someone gets poorer.

To say that everything – old stocks, startup stocks, bonds, real estate etc. – is overvalued means either nothing; or it means that the denominator, the U.S. dollar, is "underpriced". But the dollar can't become "underpriced" as a result of loose monetary policies – near-zero or negative interest rates or quantitative easing. Quite the contrary.

All these "easy" policies are basically designed to reduce the value of the currencies. (In Czechia, we have ZIRP, NIRP is unpopular with the bankers, but instead of QE, we live with with direct forex interventions keeping EUR/CZK at 27.) We may disagree with ZIRP and NIRP and QE (and surely with the forex interventions) for some moral or principled reasons. But it's almost certainly true that the inflation rate would be lower – or deflation would be deeper – if those policies haven't taken place. When it comes to the overall money supply, the policies have acted just like Milton Friedman's helicopter.

When a central bank buys up bonds, it artificially increases the demand for them, so the price of bonds goes up, and the corresponding interest rate up to the maturity (in the future) goes down. The holders of the bonds get some extra cash because they could sell the bond for a higher price than they previously expected. The future borrowers can get easy money because the interest rates have been pushed down.

All these things have the effect of making the U.S. dollar less valuable; at the same moment, they are making either particular things – bonds, directly – or all things more valuable (relatively to the U.S. dollar or the currency controlled by the central bank). At the end, it's really just the relative prices that have a physical meaning. Any step in quantitative easing is a step that makes the existing holders of cash poorer than they would be otherwise; the existing holders of bonds are wealthier than they would be otherwise. And it is easier for nations/people to borrow after the quantitative easing move because the interest rates were lowered.

And those who are in debt don't see a change because they have agreed about the exact sum how much money they should return. The only difference is that this sum may look bigger or smaller in real terms. Which way it goes? Well, the previous paragraph argued that some new cash was poured by the QE everywhere; so this increases the inflation and inflation expectations. Therefore, the loose monetary policies make it relatively easier for the existing holders of the debt to repay the debt because their nominal incomes or profits are expected to go up a little bit more quickly (or go down less slowly) because of the QE and because of the inflation that the QE encourages.

As you can see, the loose policies seemingly turn everyone into a winner. How is it possible? Shouldn't the sum of the wealth figures give you T or 100%? Yes, it still gives you 100%. This fact shows that much of the "increasing wealth" in the previous paragraph is fictitious. It is fictitious because the quantitative easing increases inflation – or reduces deflation (and the expectations).

If the QE or other loose monetary policies hadn't been adopted, the deflation would probably be deeper, and that would be better for the holders of cash. Deflation is just great news for those who hold cash. These are the real people (or companies) who are being harmed by the loose monetary policies or the QE. But they're still doing OK – at least they're not in red numbers and as soon as the inflation stays near zero, they may believe that their real interest rates stay positive (they were surely negative in several years around 2008, because of a shock increase of food prices and other reasons). And you might argue that it's "fair" to "harm" them in this way – the inflation was promised to be around 2%, so the cash holders shouldn't be allowed to be better off than these plans.
But the elevated (and perhaps really fast) inflation rate that ultimately arises from the loose monetary policies is the only downside that comes out of these policies.
If the central banks continue in ZIRP or NIRP and QE programs, we will unavoidably see the rebirth of inflation at some moment. Maybe other things aside from the central banks' activity will contribute to that. But it is inevitable that the inflation will return at some moment if the banks are working hard to pour cash everywhere (and if they realize that it's easy and relatively safe to do so more vigorously). Inflation is the only possible "punishment" for the loose (and possibly irresponsible) monetary policies.

So I just think that Thiel's and others' comments about a "bubble in everything" caused by the loose policies is a logical oxymoron. Well, you may call it a "bubble of everything" in the sense that the nominal price of everything is being pushed up, and the value of cash is correspondingly driven down. But this result – a positive contribution to the inflation rate, the rate at which the cash is losing its value relatively to everything else (nominally relatively to the baskets of products, but at some level, the products are correlated with the stocks of companies that produce them and other things) – is indeed the very goal of the loose monetary policies.

The central banks just decided that they want to have a "visibly positive" inflation – either because of some flawed moral imperatives, or because they have promised such an inflation rate and it's wrong to breach promises, especially because such deviations may bring (additional?) chaos to people's and companies' financial planning. And if a banker fails to fulfill her promises, she loses her credibility. And her credibility is a great tool she doesn't want to lose because it's a virtue allowing her to reshape the markets by opening her mouth.
However, even if you use the word "bubble" for the increased nominal prices of all things due to the loose monetary policies, it is not a bubble that should be expected to "burst".
So "the bubble" is a potentially subtle word that has several aspects and people – including Thiel – don't seem to disentangle them carefully. A bubble may mean that the air is being pumped somewhere. But if the air is pumped somewhere, it does not mean that the probability that this object bursts increases. For example, lots of oxygen was suddenly pumped to the atmosphere of Earth 2.3 billion years ago and you could have called it the Oxygen Bubble. But the oxygen is still with us. ;-) It's simply not true that everything that happens must also "unhappen". In many cases, it not only doesn't; it can't.

The idea that the "bubble" caused by the loose monetary policies will "burst" is exactly equivalent to the opinion that the pouring of the cash over the economy is not only reversible, but the reversal is unavoidable. But it's simply not true.

These QE-like operations are not reversible, or at least, they don't get reversed without the agreement by the central banks that do such things. In a very broad monetary sense, the QE activities are equivalent to Milton Friedman's helicopters. And if helicopters drop lots of cash over a city, the people pick the banknotes, hide them or spend them or eat them, and they will just not return them. If you don't believe me, try to test this question experimentally (with helicopters above Pilsen 4). Because of the increased money supply, the value of the cash goes down and inflation goes up. If the helicopter drop is a one-time event, the increase of prices following from that is a one-time event, too, and one might imagine that the prices could get reversed. But if a central bank buys over $50 billion in assets every month, and the following month, it's a fixed and unabating contribution to the trend (and to the inflation rate).

It doesn't have any "unavoidable" mirror image in the future. People who have collected the banknotes from the helicopters just won't return them without a good reason. And the people who have sold bonds to the central bank in the asset purchase program won't be able to buy the bonds again for a lower price if the QE continues.

The quantitative easing is slightly more reversible than the helicopter drops for one reason: the central banks may sell all the bonds they previously bought. This is what makes the asset purchases "safer". If one decides that it was a mistake, the effects may be basically undone. But the central bank has to agree with that. It has to actively reverse this policy. Why would it be doing such a thing? Only when something bad comes out of it and the return of the inflation is the only possible "stopper".

After 2008, Thiel's hedge fund was making some pessimistic bets on the stock markets which was an unhappy choice in 2009 and 2010. I was feeling "rationally" almost sure that the things and stock indices would return from the insanely low values of 2008 and early 2009 – both because capitalism works and the talk about the new Great Depression was greatly exaggerated; and because it's been obvious for very many years that central banks (and governments) were willing to make the monetary conditions as easy as possible. But of course, I was afraid and frustrated enough by some losses caused by unlucky purchases of stock funds in mid 2008. ;-)

But if the central banks seem to be eager to continue in the loose policies, and I think it's basically the case, they simply will. The only thing that will stop them is inflation – perhaps when the inflation rates return above 2%. But because this hasn't been the case in recent years, I think it's absolutely accurate to say that aside from some possible "microscopic distortions" of the markets, the quantitative easing programs have so far led to no macroeconomic negative consequences.

OK, how long will the central banks continue in these policies? And, almost equivalently, when will the inflation return? I don't know. The inflation could return quickly e.g. if OPEC and Russia agreed to substantially cut the oil production. But if you assume that the inflation rates remain low, well below 2% or so, one should realize that:
The ability of a central bank to weaken its own currency is basically unlimited.
This is an extremely simple observation and it seems to me that many people including Thiel fail to realize it. A central bank can print the damn banknotes, or mint the damn coins. And it can sell them by buying government bonds – but also corporate debt/bonds (ECB is already starting with that), possibly stocks, and even real estate and other things. Maybe the central bank even has the right to make the helicopter drops literally – at least with some clever trick. As long as the bulk of the economy uses these banknotes and coins, be sure that the central banks may keep on weakening the currency they control and positively contributing to the inflation rate.

As long as the central banks are allowed to buy basically unlimited types of things, you simply can't expect the central banks to "run out of the gunpowder". They have an infinite amount of that. On the other side, if they needed to strengthen their own currency (or protect it against drops), they also have some gunpowder, but they only have a finite amount of this kind of gunpowder – basically the reserves. Russia was reminded about this finiteness in 2015.

The idea that the central banks are "incapable" of achieving the positive inflation at some moment seems obviously logically flawed to me. The question is When, not If.

Finally, I want to comment on Thiel's remark that "illiquid startup investments may be a place to hide". This sentence sounds weird to me, too. These startups' being illiquid basically means that their value isn't quantified too well, so you don't really know how much you need to pay for them and how much you may get for them. There is no daily trading with their stocks etc. So if someone has access to these very special types of investments – and Thiel is lucky to be one of the people with this access – good for him and he can hide his cash over there.

On the other hand, he can also hide the incorrectness of any recommendation behind the startups' illiquidity, too. No one will know what the price actually was etc. so it will be impossible to determine whether it was a good investment.

The only qualitative aspect by which these illiquid assets differ from the other ones is that they are illiquid, i.e. their price isn't too well-defined. If you try to sell them, especially too quickly, you must be prepared to lose a big percentage of the value. There are not too many good buyers. Maybe the illiquid assets haven't made it to the quantity T above at all. But this doesn't remove them from the domain of validity of mathematics. Despite the uncertainty about their value, their price expressed in U.S. dollars obviously goes up when the value of the U.S. dollar is being reduced by the loose monetary policy. There's no way how a type of investment could avoid this logic or trend.

These secretive assets may be hard to access for most investors – aside from famous VCs like Thiels. But this inaccessibility is not correlated with the quantitative easing.

Imagine the helicopter drops. When the billions of banknotes land on Manhattan, the value of the U.S. dollar goes down. So the price of everything expressed in the U.S. dollars – whether it's liquid or illiquid, accurately quantified or not – goes up. The uncertainty \(\Delta X\) is something entirely different than the quantity \(X\) itself. Only 0.1% of investors may be capable of reasonable purchase of these illiquid assets, but this percentage is the same with ZIRP/QE or without it. So ZIRP just can't be the true cause that makes them a better investment relatively to other startups etc.

For all these reasons, I believe Thiel and many other people overestimate the actual influence of the loose monetary policies on the economy. To some extent, it's just a choice of time-dependent units (dollars etc.) of the compensations, investments, and wealth. If one says that "all prices are increased", it basically means nothing for the real economy. The bulk of the economic events occurs outside the headquarters of the central banks.

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