I have had a number of posts on liquidity over the past few years, in an attempt to explain an ill-understood phenomenon.  Here is a sampling:

Because of high frequency trading, I want to take another stab at what liquidity is.  Limit orders offer liquidity; an investor or market maker offers to buy or sell at a fixed price.  Market orders consume liquidity — they lift or hit limit orders, often forcing the bid-ask spread wider.

But not all limit orders are the same.  They vary because:

  • Some limit orders narrow the bid-ask spread, which aids liquidity.
  • Some limit orders bid/offer more shares, which increases liquidity.
  • Some limit orders hang out there for a long time, which also boosts liquidity.

Liquidity means being able to make a choice, and if possible to do it in size, at a price that you like.  Also, for many of us, it means that we have some amount of time to think about the price.  That is liquidity — the ability to buy or sell in size without having to “bust a gut” to do so.

High frequency traders claim to add liquidity, but their bids and asks are ephemeral.  They add little liquidity, because the average investor can’t act on them.  They are like market orders, because they are gone in a flash, consuming longer-dated liquidity.

I am not saying that high frequency trading should be illegal, but that investors and market makers should carefully consider the rules where they trade.  For investors: are you trading in a market where you have a disadvantage?  For market makers: you should be the heavy hitter here; don’t let anyone more powerful/fast in.  Operate your market for the best interests of all, and ignore those that want an advantage.  In some cases this may mean executing trades once every five seconds, or any such similar interval.

Level playing fields promote broad markets.  Let clever market makers so structure their businesses, that level playing fields dominate investing.

I am a risk manager first, and a profit maker second.  I tend not to trust solutions that are “magic bullets” unless there is some barrier to entry — why can you do it, and few others can?  Knowledge travels.

So, regarding the “endowment model” of investing, I have been partly a believer, and partly a skeptic.  A believer, because endowments do have the ability to invest for the long-term, and not everyone else does.  A skeptic, because many endowments were taking on too much illiquidity.

Liquidity is an underrated factor for investors who have charge over portfolios that have a long-term stable funding base.  I had that advantage once, as the main investment manager for an insurer the had a large portfolio of structured settlements.  In insurance liabilities, nothing is longer than a portfolio of structured settlements.

Buy long-dated debt?  Illiquid debt?  If the pricing is right, sure; you should have to pay to rent the strength of a strong balance sheet, where the funding is intact.  WHen managing that company’s portfolio I didn’t have to worry about a run on the portfolio, because I kept more than enough liquid assets to satisfy the demands of policyholders should they decide to surrender.

Pushing it Past the Illiquidity Limit

I decided to write about the endowment model after reading this article, of which I will quote the first paragraph:

There has been much written in the popular press lately about the failures and even the “death” of the endowment model. The discourse regarding this matter has been surprisingly simplistic, naive and exceedingly short sighted. As was the case with Mark Twain, reports on the death of the endowment model have been greatly exaggerated. Let’s start with the facts. The “endowment model” practiced by most of the big university endowments and many big foundations (but also by some astute smaller endowments and foundations) has overwhelmingly outperformed virtually all other models over any reasonable time period, and has done so for a very long time now. There is no single model, mode or manner of investing that outperforms in every environment and over every time period, and the endowment model of investing was never predicated on being the exception to this obvious reality. In fact, endowments’ time horizons are as long as any investor’s horizon, and hence are strictly focused on the long term. This is a huge advantage because there is clearly a significant liquidity premium to be captured by investing long term, not to mention the ability to better avoid the chaotic noise and behavioral finance mistakes that arise with a short term environment and outlook – especially in volatile markets.

The idea here is that you will obtain better returns if you can focus out to an almost infinite horizon — after all, endowments will last forever.  There is an edge to having a long investment horizon, but there are still reasons to be cautious, and not aim a majority of investments in such a manner that means that they cannot be touched for a long time.

Here is my example: Harvard.  At the end of fiscal 2008, those that managed Harvard Management Company were heroes.  The largest university endowment, stupendous returns, etc.  Who could ask for more?

The risk manager could ask for more.  With an endowment of nearly $37 billion in June of 2008, only $16 billion was liquid assets.  Of that $16 billion, $11 billion was spoken for because of commitments to fund limited partnerships.  Harvard also had $4 billion in debt, not all of which was directly attributable to the endowment, but still would be a drag on the total Harvard entity.   If this is representative of the endowment model, let me then say that the endowment model accepts illiquidity risk more than most strategies do.  Even after their great investment successes, Harvard did not have enough liquidity.

Then Came Fiscal 2009 — We’re out of liquid assets!

My guess is that sometime in the fourth quarter of calendar 2008, the powers that be at Harvard concluded that they were in a liquidity bind — negative net liquid assets, and there is a need for liquidity at Harvard, to pay for ordinary operations, as well as expansion.  Thus they moved to sell illiquid investments, and take a haircut on them.  They reduced their forward commitments by $3 billion.  They also raised $1.5 billion in new debt, $500 million worth of 5-, 10-, and 30-year debt each.

This is clear evidence of a panic, and an indication that the portfolio was too illiquid.  What else might indicate that?  Well, Harvard had to scale back capital projects, and had a round of layoffs of ancillary personnel.

The idea of an endowment is that you can run your institution without fear of the future.  But that also implies that those endowed will not make abnormal demands on the endowment.  That applies to the amount disbursed and the liquidity of the underlying investments.

Now at the inception of fiscal 2010, Harvard is much in the same place as it was in 2009.  Net of debt and commitments, Harvard’s endowment does not have liquid assets on net.  (My estimates: $12.5 billion of liquid endowment funds, $8 billion of funding commitments, and $5.5 billion of debt.)  Granted, it was wise to move the endowment’s cash policy target from -5% to -3% to +2% over the past two fiscal years.  Even if cash doesn’t return anything, it is still valuable.  You can’t pay professors with shares of a venture capital partnership.

The Horizon Isn’t Infinite

This brings me to my penultimate point, which is that the investment horizon for endowments is different for other investors in degree, but not in kind.  The horizon for an endowment is infinite only under conditions of permanent prosperity.  Well, anyone can invest forever under conditions of permanent prosperity.  The forever-growing investments can be borrowed against.

The investment horizon must take into account the possibility of a depression, or at least a severe recession or war, if you want to have an endowment that will truly last forever.  There has to be cash and high quality liquid debt adequate to provide a buffer of a few years of expenses.  That will give the institution more than adequate time to adjust to the new economic conditions.

Most college endowments that have not gone overboard on illiquid investments and don’t have a boatload of debt probably don’t have to worry here.  But for those that bought into the alternative investments craze, the idea of invest for forever must at least be tempered into something like 20% of our investments exist to buffer the next 5 years, and the other 80% can be invested to the infinite horizon (maybe).  That’s a more realistic approach to endowment investing, akin to a speculator paying off his mortgage and having a year of savings in the bank before beginning a trading career with capital beyond that.

Alternative Investments are not Alternative Anymore

There is another reason, though, to be cautious about illiquid investments.  With any new alternative investment class, the best deals get done first, and wow, don’t they provide a thundering return!  Trouble is, knowledge travels, and success breeds imitators.  The imitators typically bring deals that will have lower returns or higher risks than the original deals.  But the pressure of additional money into the alternative illiquid investments force progressively more marginal ideas to get done as deals.  Also, mark-to-market returns of earlier investments get marked up, giving them an even more impressive return, which attracts more capital to the investment class.

Eventually deals get done that make no sense, but the momentum of demand carries the asset class until returns of newer deals prove to be negative.  That  gets the mark-to-market process moving in reverse, and demand for the “no longer new” investment class declines.  In some cases, investors will try to get out of funding commitments, and even try to sell their interests to a third party, usually at a significant concession to the hard-to-define fair market value.

Eventually enough capital exits the class, inferior deals get written down, and the once new investment class might still be labeled “alternative,” but has entered the mainstream, because it has been around long enough to go through a failure cycle.  The now mainstream but still illiquid investment class is near a normal size versus the investment universe, and should possess forward-looking returns that embed a risk premium to reflect the disadvantages of illiquidity.  Also, the now mainstream investment becomes more correlated with risk assets generally, because the actions of institutional investors chasing past returns is common to much of what qualifies for asset allocation.

Summary

  • Liquidity is valuable, and should not be surrendered without proper compensation.
  • Alternative investment classes eventually go through a mania phase, and then go through a failure cycle.
  • After failure, they tend to be more correlated with other risk assets.
  • Endowments can indeed invest for a long horizon, but should keep sufficient liquid assets on hand to deal with significant market corrections.
  • Harvard’s endowment would be vulnerable if we had a repeat in the near term of what happened in fiscal 2009 because of its low net liquidity.

Investing is a business where the smarter you are, the more it pays to be humble and recognize risk limits.  Major universities and colleges (and defined benefit plans) should review their asset allocations and stress-test them on scenarios where liquidity is in short supply.  Better safe than sorry.

Articles on the Harvard Endowment

6:46 PM Update — So I write this, and Morningstar comes out with a good piece like this one.  So it goes.

Okay, I am going out on a limb here, so please understand that what I am saying is a bit of an experiment.  When quantitative easing was originally done in Japan, it was after:

  • a credit-fueled expansion that pushed the stock and real estate markets to new heights, which have not been seen for 19 years.
  • productive capacity was built up that the rest of the world would not need.
  • anticipated returns on equity for investment projects were in the low single digits.

Now, during the time of quantitative easing, the following things happened:

  • money market rates were near zero.
  • relatively few private investors wanted to borrow money for investments to expand productive capacity.
  • government deficits expanded dramatically in a futile attempt to simulate an over-indebted economy.
  • Speculators borrowed money in yen in order to do carry trades.  They borrowed the surplus yen from the quantitative easing, and used the leverage to speculate on higher-yielding debt.  This had little benefit for the average person in Japan, though many played the carry trade game internally, buying investments denominated in Australian, New Zealand, or US Dollars.

Back to the present, and back to the US.  Short-term borrowing rates have been falling, as there is a lack of demand to borrow short-term.  Contrast that with one year ago, where there was no lack of demand to borrow short-term, but no willingness to lend.

An amazing change indeed, but much of it stems from a lack of demand for short-term borrowing. Some attribute the low TED (3-month Eurodollar less Treasury yield) spread to risk-seeking, but I think that banks don’t have many uses for surplus cash now.

As it is, with low US Dollar LIBOR lending rates, it makes the US Dollar a honeypot for speculators.  Borrow in Dollars, invest in your favorite higher yielding currency, or in higher credit risk instruments.  For the foreign currency trade, the added kick is that the US Dollar may decline in value.  That said, many said the same would happen to the yen; that it would decline in value, and it did not.  I have many reasons to think why the Dollar will decline, but the carry trade argument goes the other way for me.

Now, maybe the excess liquidity is fostering day traders as well.  We saw the same phenomenon in 1999-2000.  The liquidity should not have leaked out, but it did, and to those that would only speculate.

So what is the Fed doing?  Is it ending quantitative easing?  It seems not.  They will buy mortgages until they reach their preannounced limit, most likely.  That said, the Treasury might reduce funding to the Fed.  They see less need to fund the Fed, though that will force the Fed to decide how large it wants its balance sheet to be in a time of crisis.

Here’s my concern — having carry traders absorb excess liquidity that the Fed has put out is a waste of Fed resources, and indicates that Fed policy is too loose.  Don’t buy more mortgages and agencies, and consider selling bonds back in to the market.  Let short-term rates rise to reflect the true scarcity of short-term ways to profit.  Let savers earn some money — there is no benefit to having monetary policy so loose.

To summarize: Japan did not benefit from many years of quantitative easing, but it provided a lot of fuel for carry trades around the world until most of them blew up over the last two years.  It seems to me that excess liquidity created by the Fed is going the same way now, because consumers and businesses don’t want to borrow to the same degree as they did during the boom phase.

It will take a long time for balance sheets to heal.  It depends upon the rates of debt forgiveness/compromise, and paying it down.  During the Great Depression, Debt/GDP peaked several years after the Depression started, and after the peak it took about ten years for it to come down to a more normal level in 1941.  I suspect that we will go through this same process again, before the economy grows robustly as it did post-1941, regardless of what the Fed and Treasury do.

It’s been two years since my last major post on this issue.  A lot has happened since then, much of which points out the truth of what I said.

If governments could be powerful enough to insure the security of individuals, and not harm the ability of the economy to grow, I would not be as strident on this point as I am.  I agree with Minsky on description, but disagree on prescription.  Minsky’s prescription was that of Keynes, but on steroids.  Run a hyper-stimulative monetary and fiscal policy.  Well, we have that now, and it is not helping much; it only balloons the national debt.  The right answer is to do almost nothing, but provide for ways to expedite bankruptcy claims.

Why such a harsh prescription?  We don’t want financial institutions, much less large ones, to rely on the idea that the Federal Government has their back.  That leads to excessive risk-taking.  We also should not want the US Government to be deeply involved in the financial sector for several reasons:

  • The Treasury will be captured by financial interests (already done!)
  • Fair pricing of loan yields versus marginal cost of taxation will get muddled.
  • Political haggling will choke Capitol Hill.
  • The blob will grow.  No, not the Department of Education, a la William Bennett.  I am talking about the Fed.
  • Individuals and corporations will be more cautious about their finances, and will manage them more prudently.

Aside from constraining the total leverage of the economy, which I have suggested in the past, there is no way of escaping the pains of the boom-bust cycle.  I would say to everyone, “Grow up.  Our Government can’t control the economy in the long run, so accept that, and live with the boom-bust cycle.  Eliminate government meddling, especially the Fed.  All attempts to smooth the cycle lead to a bigger bust later.  Would you rather take some pain now, or risk the creditworthiness of our nation?”

One reader has recently asked me about sovereign defaults.  I need to think about that, and give you all a better piece later, but this is not a time to be careless about the US, unless the political mood so changes, that large tax increases would happen.

What Stories Aren’t Being Told? was my most commented piece since the inception of this blog, and I thank readers.  But Dr. Jeff pointed out in the comments, the tone was on of extreme negativity.  What?  Is there nothing going right that is under-reported?  Here are a few ideas from me:

  • Credit spreads are below average in general.
  • Energy prices have moderated, particularly for those who buy natural gas at spot rates.
  • There is still very good foreign demand for Treasury auctions.  Oh, Treasury yields are low.
  • On the low/middle end of housing, where there are conforming mortgages, the market has come into equilibrium, where bargains are balancing out more foreclosures in the future.  This may not apply in the really hot markets of 2005.
  • Dividend decreases seem to have stopped.
  • Corporate balance sheets seem to be more able to handle additional pressure.
  • The insurance industry seems to be in very good shape, aside from that faker, AIG.

Okay, the same as last time, I offer this to my readers in the comments section — what is going right now, particularly in what is not being reported.  It can be small or large issues.  Let me know.  Last last piece got a lot of play, even the comments, so let me know what you think.

1) Credit cycles tend to persist for more than just one year.  That is one reason why I am skeptical of the run in the high yield corporate bond market at present.  Sharp short moves are very unusual.  To use 2001-2003 as an example, we got faked out twice before the final rally commenced.  So, as I look at record high defaults after a significant rally, I am left uneasy.  Yes, defaults have been less than predicted, but defaults tend to persist for at least two years, and current yields for junk don’t reflect a second year of losses in my opinion.  S&P is still bearish on default rates.  I don’t know if I am that bearish, but I would expect at least one back-up in junk yields before this cycle ends.

2) Of course, there are bank loans in the same predicament.  Most bank loans are not listed as trading assets, so they get marked at par (full value) unless a default occurs.  Along with Commercial Real Estate loans, this remains an area of weakness for commercial banks.

3) Where should your asset allocation be?  Value Line is more bearish than at any time I can remember — though the last time they were more bearish was October 2000.  Good timing, that.

David Rosenberg favors high quality bonds over stocks in this environment, which is notable given the low yields.  For that bet to work out, deflation must persist.

One reason this still feels like a bear market is that there are still articles encouraging a lesser allocation to stocks.  Though one person disses the traditional 60/40 stocks/bonds mix, in an environment where complex asset allocations are getting punished, I find it to be quite reasonable.

4) Maybe demographics are another way to consider the market.  When there are more savers/investors vs. spenders, equity markets do better.  I’ve seen this analysis done in other forms.  So we buy Japan?  I’m not ready for that yet.

5) Illiquid assets require a premium return.  After the infallibility of the Harvard/Yale model, that rule is on display.  As their universities began to rely on their returns, even though there was little cash flowing from the investments, they did not realize that there would be bear markets.  Harvard and Yale may indeed have gotten a premium return versus equities.  It’s hard to say, the track record is so short.  One thing for certain, they did not understand the need for liquidity; a severe present scenario has revealed that need.  As such, investors in alternative investments are looking for more liquidity and transparency.

6)  There are limits to arbitrage.  As an example, consider long swap rates.  30-year swap yields should not be less than Treasury yields — they are more risky, but do do the arbitrage, one would need a very strong balance sheet, with an ability to hold the trade for a few decades.

7) One thing that makes me skeptical about the present market is the lack of deployment of free cash flow in dividends or buybacks.  When managements are confident, we see that; managements are not yet confident.

8 ) I would be wary of buying into a distressed debt fund.  Yields have come down considerable on distressed debt, and I think there will bew better opportunities later.

9) It seems that the US Dollar, with its cheap source of funds for high quality borrowers, is attracting some degree of interest for borrowing in US Dollars in order to invest in other higher yielding currencies.  I’m not sure how long that will last, but many see the combination of a low interest rate and a potentially deteriorating currency as attractive to borrow in.

10) The difference between an investor and a gambler is that an investor bears risk existing in the economic system in order to earn a return, whereas the gambler adds risk to the economic system that would not have existed, aside from his behavior.

I have never been a fan of VAR (Value at Risk), but I recognize that mathematical techniques are only as good as those that use them.  Questions arise with any quantitative risk technology:

  • What’s my time horizon?  (What’s your longest asset or liability?)
  • Do I have to be good over this entire time horizon, or just the end?  (The whole thing, sorry.)
  • How do I work with options in assets or liabilities?  (Assume optimal exercise by the option holder.)
  • What are the worst losses can I take from this business activity?  (Much worse than you can assume, and this present crisis is an example of that.)
  • How do I model liquidity of liabilities?  (Assume they exit when it is in their interest.)

With one employer, he invited me to consult for the Asset-Liability committee of his bank.  Having been a risk manager inside two life insurance companies, when I reviewed the documents, I was surprised, because they were so much less sophisticated than what life companies of a similar size did.

With banks, the grand weakness is in the assets, and the analysis should focus on two things:

  • Liquidity of the assets versus liquidity of the liabilities.
  • Potential credit losses of the assets versus the surplus of the bank.

I write this because of the commentary of Taleb and Bookstaber.  They are bright men, but they have never managed the risks of a financial institution.  Leverage ratios are not enough.  One must dig into the loss experience and analyze whether emerging losses might overwhelm the capital of the institution.  One must also look at risk-based liquidity — what is the likelihood  of running out of cash?

There is always a tension between rules versus principles.  What must first be admitted is that both can be fuddled by sinful men.  Rules can be observed, and cheaters bring items that meet the letter of rules, but violate the spirit of the rules.  Principles can be bent by those that implement the principles.  Neither is a perfect solution — better to settle on one way of regulating, though, and understanding the soft spots, than to vacillate.

Perhaps the banks need to employ actuaries.  I don’t say that so that friends might find work, but because many banks do not get how to preserve their existence.  Actuaries think longer-term; they think about scenarios where loss experience might prove to be unsustainable.  They are more skeptical on risk compared to most bankers.

With that, I commend all who read this to be careful, and to analyze financial situations carefully.  Don’t follow the crowd.

Before I start this evening, thanks to all my readers who commented on my post yesterday.  It was my biggest response ever.  I sent to the reporter my summary of your comments.

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For my last employer, back in 2004, since I had a big position on in the hedge funds in equity sensitive life insurers, I went to a Morgan Stanley “teach-in” on esoteric issues on reserving and required capital.  Strangely for me, I arrived first, and waited for others to show.  If you’ve ever met me, you would see me at such a time pull out my “reserve reading,” and redeem the wait time by catching up on my reading.

Well, being there first did have an advantage in greeting people.  “Who are you with?”  The answer was usually some asset management firm.  But when two particularly well-dressed fellows showed up, the answer was “The Federal Reserve.”

“Huh?” I responded.  “What interest would the Fed have in insurance reserving?”

“We follow all areas of the financial markets,” he smiled as he and his partner took a seat behind me.  Aside from the presenter that Morgan Stanley brought in, I think I was the only actuary in the room, which made for an interesting dynamic.  I tried not to ask any “inside game” questions, but poked at some of the assumptions embedded in the analyses.  The guys from the Fed were quiet as clams.  Sure beats working for a living.

Now, it wasn’t the first time I had bumped into economists from the Federal Reserve at conferences.  Half a year earlier, I bumped into some of them at a Credit Suisse conference on insurance.  Why they wasted time listening to pitches from management teams that they do not regulate was beyond me.

So, after my recent piece, Waiting for the Death of the Chicago School, and the Keynesian School also, Redux, when I read the piece Priceless: How The Federal Reserve Bought The Economics Profession, I said to myself, “I knew about that.  Why didn’t I write about that?”

The Fed hires Ph.D. economists.  Lots of them.  It gives the Fed a large contingent of intellectual defenders.  It helps them marginalize critics.  Because of their size, they have considerable sway over academic journals, and over invitations to prestigious conferences (dey got money mon).

There is a kind of paradigm a la Thomas Kuhn here, (Structure of Scientific Revolutions) where the dominant paradigm is well-supported economically, and self-interested, but it is false, and being attacked by poorly-funded nobodies who only have the truth on their side.

The Fed does not need most of the people that work for them.  They have two main functions — monetary policy and banking supervision.  They could do those tasks with 20% or less of the personnel.  Not that I want to unemploy a bunch of economists, but why should they be implicitly funded by the US government?  Why should they be doing academic studies?

Now, some will say that it is a private institution, and it can do as it wishes.  It is not a purely private institution:

  • Chairman and board members are appointed by the president and approved by the Senate.
  • Congress has an oversight role on what the Fed does.
  • Profits from the Fed flow back to the Treasury.
  • They have considerable influence over the theories of economics that are used to evaluate their performance.
  • They administer many of the major money transfer systems between institutions.
  • They are a major player in regulating the banks (or not) — if the Fed doesn’t get the other regulators to cooperate, you have a mess like we did 2003-2007.
  • They affect the value of our currency in the long run, and in the short-to-intermediate run, induce booms and busts in our economy, banks and bond markets.
  • Given the systematic risk that engenders, many suggest that the the Fed should regulate that as well.

A purely private institution should not have that level of influence across the economy as a whole.  The antitrust folks get concerned over any entity monopolizing an industry, but this is a greater monopoly still, were it purely private.

The Fed is a chameleon — it’s public when it wants to be, private when it wants to be and both or neither if that serve them well at the moment.  I support the idea of auditing the Fed, but I really think we need is a broader debate on what the Fed should do in our country, and whether the authority and size of the institution should not be reduced.

I did not start blogging in order to start a media career, but sometimes the media finds its way to my door.  I received a call today from a reporter for one of the major television networks, and after talking a while, she asked me, “What big stories aren’t being told?  Some of my best stories some from asking this question.”  I told her I needed to think, and would e-mail her back on the topic.  I decided I would review my last month of posts to look for out-of-consensus ideas, and I came up with these:

  • China is overstimulating businesses through loans and they are buying up commodities that they don’t need now, leading to a possible correction in commodity prices.
  • Western European banks are in trouble because of loans to Eastern European nations denominated in Euros.  With the rise in the Euro, defaults are likely.
  • Water shortages in China and India.
  • Most entities that the US Government has bailed out will have stocks that are zero eventually — GM, Chrysler, AIG, and maybe Fannie Mae and Freddie Mac.  For an opposing opinion on the GSEs, read the intelligent John Hempton at Bronte Capital.
  • With dud residential mortgage loans, modifications don’t work well unless there is a forgiveness of some of the principal.
  • The foreign funding base of the US is getting shorter in maturity — could this be a sign of trouble?  Is there a lack of confidence?
  • If we marked the value of commercial real estate loans to market for banks, using data from the CMBS market, some banks would be insolvent.

That’s all for me, or now.  Now, I don’t watch television, listen to radio much, and I don’t subscribe to anything aside from the WSJ.  I don’t see everything.  That is why I am asking my clever readers to answer the question that the reporter asked me — what significant economic stories aren’t being told?  These can be small issues as well as big issues.  Please let me know in the comments below.  Thanks.

Monetary inflation leads to inflation in goods, services, and/or assets.  We just went through a decade (and then some) where there was low product price inflation, but there was significant inflation in asset values.

What was the response from policymakers?  Aside from a rare comment regarding “irrational exuberence,” most of the time they were fat, dumb, and happy.  Because of their flawed model for understanding monetary policy, they ignored asset inflation, and patted themselves on the back for the lack of goods price inflation.  What little attention they paid was through the weak construct called the “wealth effect.”

Make no mistake — printing money leads to inflation; the question is where the inflation goes.  The loose monetary policy of the last 20 years has definitely fueled an inflation of real estate asset values above that which is sustainable in the long run.

As such, I have little agreement with the following articles:

We have been through a unique era where monetary has had significant effect on the asset markets, but little effect on the goods markets.  Perhaps those effects were affected by demographics, and might change in the future.  Just because good price inflation has been weak in the past, does not mean it will be weak in the future.

Monetary inflation — an increase in the money stock or credit, will have an impact on asset and/or goods prices.  Which gets affected depends on the proclivity to spend versus save.

There is real reason to be concerned about inflation, then.  We face either:

  • an unsustainable increase in asset values, or
  • goods and product price inflation.

The former looks for likely for now, but who can tell?  As Baby Boomers tip the balance between saving and spending, goods and services inflation may predominate over asset inflation.

On the “positive” side, some of the troubles of asset inflation get passed on to credulous foreigners because the dollar is the world’s reserve currency.  That weakens the feedback effects in the short run.

My main point is this: there is no free lunch.  Either money buys less, or assets buy less because of monetary inflation.