Jan 27, 2009
Keynes, Shiller, and the Economy’s Animal Spirits
Yesterday, I read the Bill and Melinda Gates Foundation’s annual letter. You can .
In Gates’ letter, he mentions that one of the problems facing the Gates foundation and really all philanthropic organizations is the economy. When times are good, people are usually more likely to give away money. With asset prices falling, the likelihood of that is less. Gates quoted a passage from John Maynard Keynes in his letter, which he said was sent to him by Warren Buffett:
“This is a nightmare, which will pass away with the morning. For the resources of nature and men’s devices are just as fertile and productive as they were. The rate of our progress towards solving the material problems of life is not less rapid. We are as capable as before of affording for everyone a high standard of life—high, I mean, compared with, say, twenty years ago—and will soon learn to afford a standard higher still. We were not previously deceived. But today we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time—perhaps for a long time.”
The problem that Keynes saw at the time was one in which the lenders stopped lending and factory owners stopped producing goods because they feared that there would be no one to sell to. The following passage has certain parallels to what we’re experiencing now:
Why is there an insufficient output of new capital-goods in the world as a whole? It is due, in my opinion, to a conjunction of several causes. In the first instance, it was due to the attitude of lenders—for new capital-goods are produced to a large extent with borrowed money. Now it is due to the attitude of borrowers, just as much as to that of lenders.
For several reasons lenders were, and are, asking higher terms for loans, than new enterprise can afford. First, the fact, that enterprise could afford high rates for some time after the war whilst war wastage was being made good, accustomed lenders to expect much higher rates than before the war. Second, the existence of political borrowers to meet Treaty obligations, of banking borrowers to support newly restored gold standards, of speculative borrowers to take part in Stock Exchange booms, and, latterly, of distress borrowers to meet the losses which they have incurred through the fall of prices, all of whom were ready if necessary to pay almost any terms, have hitherto enabled lenders to secure from these various classes of borrowers higher rates than it is possible for genuine new enterprise to support. Third, the unsettled state of the world and national investment habits have restricted the countries in which many lenders are prepared to invest on any reasonable terms at all. A large proportion of the globe is, for one reason or another, distrusted by lenders, so that they exact a premium for risk so great as to strangle new enterprise altogether. For the last two years, two out of the three principal creditor nations of the world, namely, France and the United States, have largely withdrawn their resources from the international market for long-term loans.
Meanwhile, the reluctant attitude of lenders has become matched by a hardly less reluctant attitude on the part of borrowers. For the fall of prices has been disastrous to those who have borrowed, and anyone who has postponed new enterprise has gained by his delay. Moreover, the risks that frighten lenders frighten borrowers too. Finally, in the United States, the vast scale on which new capital enterprise has been undertaken in the last five years has somewhat exhausted for the time being—at any rate so long as the atmosphere of business depression continues—the profitable opportunities for yet further enterprise. By the middle of 1929 new capital undertakings were already on an inadequate scale in the world as a whole, outside the United States. The culminating blow has been the collapse of new investment inside the United States, which to-day is probably 20 to 30 per cent. less than it was in 1928. Thus in certain countries the opportunity for new profitable investment is more limited than it was; whilst in others it is more risky.
A wide gulf, therefore, is set between the ideas of lenders and the ideas of borrowers for the purpose of genuine new capital investment; with the result that the savings of the lenders are being used up in financing business losses and distress borrowers, instead of financing new capital works.
At this moment the slump is probably a little overdone for psychological reasons. A modest upward reaction, therefore, may be due at any time. But there cannot be a real recovery, in my judgment, until the ideas of lenders and the ideas of productive borrowers are brought together again; partly by lenders becoming ready to lend on easier terms and over a wider geographical field, partly by borrowers recovering their good spirits and so becoming readier to borrow.
Seldom in modern history has the gap between the two been so wide and so difficult to bridge. Unless we bend our wills and our intelligences, energized by a conviction that this diagnosis is right, to find a solution along these lines, then, if the diagnosis is right, the slump may pass over into a depression, accompanied by a sagging price-level, which might last for years, with untold damage to the material wealth and to the social stability of every country alike. Only if we seriously seek a solution, will the optimism of my opening sentences be confirmed—at least for the nearer future.
It is beyond the scope of this article to indicate lines of future policy. But no one can take the first step except the central banking authorities of the chief creditor countries; nor can any one Central Bank do enough acting in isolation. Resolute action by the Federal Reserve Banks of the United States, the Bank of France, and the Bank of England might do much more than most people, mistaking symptoms or aggravating circumstances for the disease itself, will readily believe. In every way the more effective remedy would be that the Central Banks of these three great creditor nations should join together in a bold scheme to restore confidence to the international long-term loan market; which would serve to revive enterprise and activity everywhere, and to restore prices and profits, so that in due course the wheels of the world’s commerce would go round again.
Keynes’ solution was that central banks needed to come together and take unified action in order to shore up confidence. Today’s Wall Street Journal had a great article penned by Yale’s Robert Shiller about the difficulties behind rallying confidence:
The term “animal spirits,” popularized by John Maynard Keynes in his 1936 book “The General Theory of Employment, Interest and Money,” is related to consumer or business confidence, but it means more than that. It refers also to the sense of trust we have in each other, our sense of fairness in economic dealings, and our sense of the extent of corruption and bad faith. When animal spirits are on ebb, consumers do not want to spend and businesses do not want to make capital expenditures or hire people…
A critical aspect of animal spirits is trust, an emotional state that dismisses doubts about others. In talking about animal spirits, Keynes sought to convey the message that swings in confidence are not always logical. The business cycle is in good part driven by animal spirits. There are good times when people have substantial trust and associated feelings that contribute to an environment of confidence. They make decisions spontaneously. They believe instinctively that they will be successful, and they suspend their suspicions. As long as large groups of people remain trusting, people’s somewhat rash, impulsive decision-making is not discovered.
Unfortunately, we have just passed through a period in which confidence was blind. It was not based on rational evidence. The trust in our mortgage and housing markets that drove real-estate prices to unsustainable heights is one of the most dramatic examples of unbridled animal spirits we have ever seen.
Furthermore, while animal spirits have been high over a very long period of time, a whole new system for the granting of credit had been generated. Some 30 or 40 years ago there was much less intermediation in financial markets. But then along came financial innovation and a new financial system, not just in mortgages and housing but throughout the credit system, with complicated strategies of securitization and use of derivatives. The more complex the transaction the more trust is needed to sustain the transaction.
Shiller offers us a few ways officials could get the animal spirits confidence again:
So what must we do to revive our animal spirits and economic growth? We must be certain that programs to solve the current financial and economic crisis are large enough, and targeted broadly enough, to impact public confidence. Not only do we need a fiscal stimulus significantly greater than the proposal that is currently on the table, government action is also needed to take the place of the credit markets that seemingly worked so well when animal spirits were high. The Treasury and the Federal Reserve not only need a fiscal target, they also need a credit target. This should not be a dollar number, but rather a target for how the credit markets should behave. The goal should be that those who would normally receive credit in times of full employment can once again find it easy to do so, at rates with realistic risk premiums.
There are three ways to restore these credit markets. The Treasury and the Federal Reserve have been inventive in applying all three methods. The first is the extension of rediscounting. The Fed has invented many different special loan facilities. They have even invented ingenious ways to combine Treasury money to make very large-scale loans while still within the legal requirement that the Fed can only lend against safe collateral when using TARP funds for the Term Asset-Backed Securities Loan Facility, which will support consumer, student and small-business loans. But so far the total amount of such rediscounting has been small relative to the size of the credit markets. They need to be much larger.
Second, so far more than $250 billion of government money has been used to recapitalize banks. But just making the banks solvent is not enough. The banks, whose managers are suffering from the same flagging animal spirits as the rest of the economy, will not expand their credit much just because they are more solvent. The banks will only expand if they see profitable opportunities to grant loans and if their fear of failure is diminished. It will take much more than keeping the banks solvent to make them take on the disappeared credit flows.
And, finally, especially in considerably expanding the powers to support the lending of Fannie Mae and Freddie Mac, government-sponsored enterprises have replaced a significant portion of the mortgage markets. But the government should do much more here as well. For example, failed banks might be kept alive longer as bridge banks under government supervision with the purpose of making credit freely available.
I don’t want to veer off too far into economics. When I invest, I tend to view economics from a very limited perspective and prefer to focus more on bottom-up factors. But I think that in the solutions Shiller outlines, we can see some of the risks that still exist in our financial system. For much of January, the market has rocketing upwards, but maybe we should exercise a bit of restraint until we see more done by the government in terms of fixing the broken banks and pushing for lending to resume.
With that in mind, I’ve been looking at adding to my portfolio. I’ll likely be reducing my position in Fairfax Financial, it’s around 50% of the portfolio. Instead, I’ll take an approach of adding small positions and gradually increasing them, with the volatility I’ve seen in the past 3 months, this method might be more useful than buying all at once.