Wednesday, October 21, 2009

Taipan Daily: The Engineers of Inflation

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Wed., October 21, 2009
Taipan Daily: The Engineers of Inflation
by Justice Litle, Editorial Director, Taipan Publishing Group

On Nov. 7, 1940, at 11:00 a.m. PT, the Tacoma Narrows Bridge collapsed in Washington state.

The bridge was nicknamed “Galloping Gertie” because of its instability in high winds. At 5,939 feet, it was the third-longest suspension bridge in the world – behind only the George Washington Bridge and San Francisco’s famed Golden Gate.

Gertie opened to the public on July 1, 1940. Less than five months later, 40-mile-per-hour winds caused the bridge to vibrate so violently it shook itself apart.

The problem was ultimately determined to be something called “aeroelastic flutter.” A commission of the Federal Works Agency, formed to study the collapse, further weighed the impact of “self-induced vibrations in the structure” and “random effects of turbulence.”

As a result of the disaster, engineers learned a lot about feedback loops and resonance effects.

A feedback loop takes place when a repeated action feeds on itself. Like a child in a swing, for example. As the child pumps her legs to create back-and-forth movement, a gravity/inertia feedback loop kicks in, causing the swing to move in wider arcs with each pass.

Resonance effects are a little more abstract, but basically the same idea. As a result of Tacoma Narrows, engineers discovered that a bridge can have a certain “natural frequency.” If wind hits the bridge in just the right way, it’s like pinging a tuning fork for maximum vibrations (of the very dangerous sort).

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Civil Versus Financial

Civil engineers (i.e. bridge builders) and financial engineers have more in common than one might think. (That’s partly why they call it “structured finance.”) But as Richard Bookstaber and others have pointed out, there is something very odd about the financial engineering biz.

America hasn’t seen a suspension bridge collapse comparable to Tacoma Narrows in well over half a century. The civil engineers well and truly learned from what went wrong, and figured out how to fix it.

In the world of financial engineering, though, it’s a whole different story. When it comes to suspension bridges built on Wall Street, the equivalent of a Tacoma Narrows disaster seems to happen every five to seven years!

Why such different results? One can only speculate, but the logical culprit seems to be incentives.

If a civil engineer builds a bridge that collapses, he (or she) is likely to be humiliated and distraught – even a temporary suicide risk. (Fortunately no lives were lost in the Tacoma Narrows incident, other than a cocker spaniel named Tubby.)

If a financial engineer builds a bridge that collapses, on the other hand, he is likely to be consoled by the hundreds of millions of dollars in his firm’s pocket, coupled with a prevailing attitude of “c’est la vie” (such is life).

Wall Street is a serial bridge collapser, in other words, because the act of building the bridge is almost always richly profitable... and the cost of collapse typically falls on someone else.

An Inflationary Nash Equilibrium

This partially explains, too, why the financial world can erupt in celebration even as foreclosure victims check into homeless shelters (an up-and-coming development per The New York Times).

Think of the real economy as a suspension bridge: Tacoma Narrows writ large. Deliberately inflationary pro-Wall Street policies (excess money printing, unlimited bailout funds and so on) are like high winds lashing the bridge.

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Once again, feedback loops and resonance effects threaten to shake the bridge apart. The stronger the feedback, the more things start to wrench and sway. But this time the engineers don’t care...

As far as the stock market goes, Washington, Wall Street and long-only money managers have discovered something called a Nash equilibrium.

A Nash equilibrium, named after the brilliant mathematician John Nash, exists when two or more players reach a point where everyone is implementing an optimal strategy (given the dynamics of the situation). As Wikipedia puts it,

Amy and Bill are in Nash equilibrium if Amy is making the best decision she can, taking into account Bill's decision, and Bill is making the best decision he can, taking into account Amy's decision. Likewise, a group of players is in Nash equilibrium if each one is making the best decision that he or she can, taking into account the decisions of the others.

In a deliberately inflationary environment, the players involved are content because everybody wins. The government can point to a rising Dow as a counter to those who rudely fixate on the problems of the real economy. Goldman Sachs, J.P. Morgan and others can book record “trading profits” (i.e. leveraged government handouts) to offset lackluster results in other areas of the business. Money managers can high-five each other and pretend it’s a new bull market.

The spoiler here is the U.S. consumer and anyone with stronger ties to the real economy than the paper economy. While rampant money printing is great for paper assets, it’s hell for most real businesses.

Consider, for a moment, the perversity of Wall Street’s attitude toward the oil price. Upward movement in crude these days is seen as a wonderful thing. And if one is leveraged long oil stocks, then hey – perhaps oil on a tear really is a wonderful thing.

But look at it from a broader perspective. The first time the Dow broke that magic level of 10,000, back in 1999, gasoline was $1.20 per gallon and the dollar had 30% more purchasing power than it does now. So now hooray, let’s rejoice because gasoline prices are set to... triple and quadruple?

Things Fall Apart

The trouble with deliberately engineered inflation can be summed up in three words (as memorably employed by Yeats): Things fall apart.

In the long run, the success of the paper economy still depends on the health and soundness of the real economy. Wall Street, in all its glory, is still a free rider (some would say parasite) on the back of Main Street.

This is why the center cannot hold. To the degree that connected players can keep asset prices aloft on a geyser of paper money, the illusion of prosperity can be sustained (for those who don’t care to look too closely).

But the more inflation we deliberately inject into the system, the more that the real economy “bridge” starts to twist and shake. To imagine the present arrangement can go on indefinitely is to picture a world in which gasoline at $10 a gallon, an average grocery bill of $3,000 a month, and real unemployment at 25% are all acceptable outcomes.

This, too, speaks to the laughable irony known as the Consumer Price Index. By most measures, the CPI tells us that inflation is “under control.” Sure fellas, of course it is. Way to keep our minds off the printing press (where the real inflation is taking place). This crude oil chart sure looks “under control” to yours truly...

View Chart of Crude Oil Futures

The Risk of Collapse

Last week, blogger Mike “Mish” Shedlock asked the question, “Is the stock market a leading indicator?”

To answer the question, he looked at S&P 500 charts dating back to 1982 to determine whether movement in stock prices accurately foretold positive or negative developments in the real economy.

Mish’s conclusion: “The theory that the stock market is a reliable leading indicator is a myth easily shattered by simple observation of the facts.” (You can find the original post here.)

If you agree with Mish (and your editor more or less does on this point), that means the stock market doesn’t actually have much to say about “what’s next” for the real economy. The stock market has become wholly a game unto itself, driven by the short-term profit motives of the players involved.

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The original purpose of the stock market – to function as an efficient mechanism of resource allocation, sending investment capital to where it can be used most productively in the real economy – has taken a back seat to chicanery.

This is wholly logical in light of the Nash equilibrium point made earlier. If the financial engineers at the table are able to enrich themselves right now, who gives a rip about what happens down the road? Why would accurate forecasts or reasonable valuations be allowed to get in the way of short-term profit considerations? If the real economy is getting screwed, who cares?

This mindset further explains why Wall Street seems to have a new “Tacoma Narrows” experience every few years or so. The serial bridge collapsers get richer with each debacle – and in that regard, the current White House administration is proving to be the greatest enabler in all of U.S. financial history.

As QB Partners recently put it in its September investor letter,

If we were to attach a label to this system it would not be “free-market capitalism”... the most honest description would be “bank-centric socialism” in which the real value of a nation’s resources and capital production takes a back seat (and is ultimately effectively confiscated) by the state and by the nation’s financial network.

“Bank-centric socialism” is what we are experiencing here and now, as you read this. Deliberately created inflation – paper asset inflation, with the spoils channeled and funneled into select hands – is the means by which it occurs.

Real wealth comes from productivity and hard work. It can’t be created at the touch of a button on the whim of a central bank. What the engineers of inflation have figured out, however, is a way to drain the lifeblood from the real economy drop by drop.

There is only one problem with the scheme as it exists now. While the phenomenon of serial bridge collapse can easily be tolerated at modest scale, the size of each collapse just keeps getting bigger... and the next one could be a real doozy.

Warm Regards,


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