Bill Shughart has a second essay published by The Independent Institute, on the unjustified and dangerous recent expansion of the powers of the Federal Reserve. A selection:
By signing legislation creating Medicare Part D, George W. Bush became
responsible for the most significant expansion of the welfare state
since LBJ’s Great Society. It turns out, though, that forcing taxpayers
to help buy Granny’s meds was the proverbial camel’s nose of big
Republican government. So what was next? The overhaul of financial
market regulation announced recently by Treasury Secretary Henry
Paulson, which, if adopted, would extend the federal government’s reach
more so than any policy initiative since the New Deal.
Intended to prevent recurrence of the turmoil triggered by the
bursting of the housing bubble, the administration proposes to
restructure the responsibilities of the agencies who now oversee U.S.
financial market operations, in ways that supposedly would promote
regulatory information-sharing, cooperation and coordination.
In an earlier crisis atmosphere, similar goals justified cobbling
together the Brobdingnagian Department of Homeland Security, which just
goes to show that, while interagency information-sharing and
coordination sound good in theory, they are unlikely to be achieved in
actual bureaucratic practice.
But the most troubling aspects of the Treasury’s blueprint for
reforming financial market regulation are found in the far greater
powers it assigns to the Federal Reserve.
One part of the plan simply affirms actions the Fed already has taken.
Apparently concluding that Bear Stearns was too big to be allowed to
fail, the Fed, for the first time in its history, granted to such non-bank
financial institutions access to loans at its "discount window" — loans
previously restricted to commercial banks — and guaranteed $29 billion
in illiquid assets to broker Stearns’s purchase by JPMorgan Chase.
So now that the Fed has lent those billions more to Goldman Sachs,
Lehman Brothers, Morgan Stanley, and other Wall Street securities’
brokers, the Treasury proposal would permit the central bank to conduct
on-site inspections and impose conditions, including capital
requirements, on such borrowers — which it now is doing without
explicit authority.
And most worrisome, the regulatory reform plan also empowers the Fed
to ensure "market stability," watching for threats originating anywhere
within the financial system, be it from commercial banks, investment
banks, mortgage lenders, hedge funds or insurance companies.
As economists have asked: if smart, highly paid Wall Street
investment bankers with huge financial positions on the line failed to
foresee the risk to which subprime mortgages exposed them, how can one
expect a regulatory agency to do so? And, what steps will the central
bank take to "stabilize" markets, if it does perceive a threat? Will it
continue to bail out institutions who run into financial trouble?
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BANKERS OWN THE WORLD…
as explained by Sir Josiah Stamp, President of the Bank of England and the second richest man in the British Empire, in an informal talk to 150 University of Texas history, economics and social science professors, in the 1920's:
"The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was every invented. Banking was conceived in inequity and born in sin …. Bankers own the earth. Take it away from them but leave them the power to create money, and with a flick of a pen, they will create enough money to buy it back again …. Take this great power away from them and all great fortunes like mine will disappear, for then this would be a better and happier world to live in …. But if you want to continue to be the slaves of bankers and pay the cost of your own slavery, then let bankers continue to create money and control credit.
I'm sorry but I have to ask, "Where's the beef?" The article seemed to contain little more than hand waving.
If the Fed is going to allow loans at its discount window it seems perfectly reasonable to me that they define the criteria that must be met. For banks, knowing their books will be scrutinized creates a disincentive for banks to use it.
While I have little doubt that regulations would favor large institutions over smaller ones the case cited seems rather anecdotal. It must be mentioned that correlation is not causation. There are a lot of reasons why smaller financial institutions were in a precarious and less secure financial position in 2002 and 2003. Not the least of which was the recession we were in at the time.
I'm sorry but I have to ask, "Where's the beef?" The article seemed to contain little more than hand waving.
If the Fed is going to allow loans at its discount window it seems perfectly reasonable to me that they define the criteria that must be met. For banks, knowing their books will be scrutinized creates a disincentive for banks to use it.
While I have little doubt that regulations would favor large institutions over smaller ones the case cited seems rather anecdotal. It must be mentioned that correlation is not causation. There are a lot of reasons why smaller financial institutions were in a precarious and less secure financial position in 2002 and 2003. Not the least of which was the recession we were in at the time.
Marcus wrote: "For banks, knowing their books will be scrutinized creates a disincentive for banks to use it."
This may be true, but disincentive or not, the point is that A NEW POWER WILL BE GRANTED TO THE FED. If the "beef" were a snake it would surely bite Marcus.
This may be true, but disincentive or not, the point is that A NEW POWER WILL BE GRANTED TO THE FED. If the "beef" were a snake it would surely bite Marcus.
– Posted by: indiana jim | Apr 17, 2008 9:34:48 AM
Yet more hand waving with no substance.
First, it is not a new power, it is an extension of existing power.
Banks have always had access to the Fed's discount window and, as far as I'm aware, under the same terms. The Fed is now broadening access to that 'window'.
I can think of a number of arguments against that extension which don't involve hand waving or subtle insults. Not the least of which is the fact that capital ratio requirements and having access to the discount window did not prevent banks, like Citigroup, from getting into the position they're in today.
Yet, investment banks, like commercial banks, have similar business models. They borrow short to lend long. Such a business model is vulnerable to 'bank runs'.
Milton Friedman taught us that the bank failures in the early 30's could have been prevented if the Fed's simply provided them with enough liquidity to survive such a run.
Since that time, investment banks have become a significant cornerstone of our financial system. To not provide them with the liquidity they need to survive such runs seems rather naive to me and certainly ignores the lessons Milton Friedman taught us.
Time to bring back good ol' gold and silver coins?
Marcus,
Since that time, investment banks have become a significant cornerstone of our financial system. To not provide them with the liquidity they need to survive such runs seems rather naive to me and certainly ignores the lessons Milton Friedman taught us.
You're propagating the fiction the government is using as justification to expand its power. Investment banks are basically doing the same thing they've always done. They are not depository institutions and grandma and grandpa aren't about to launch a run on them. Their creditors may push them into bankruptcy, but so what? The market might suffer for it but since when has the U.S. economy been defined as "the stock market"?
The Fed's new mandate ensure "stable markets" can only be accomplished by restricting growth, innovation and flexibility. Is this really a winning formula?
The only way for the Fed to try to stabilize the market is through price floors and caps. However, price caps will not prevent bubbles – if a price cap is set too high, there's still room for a bubble. Setting it too low will create shortages. If price controls worked, Europe and the USSR would have surpassed the U.S. in economic growth. In essence, market stability is not that much different from a fully planned economy, only through indirect means.
Incidentally, I think it's a mistake and an abuse of the Fed's power to allow investment banks to belly up to the discount window.
Gil says:
Time to bring back good ol' gold and silver coins?
and like I said to Gil recently in previous posts:
You don't ever seem very interested in truly engaging the topic at hand. You seem to be more inclined to "look for" something irrelevant, wrong or weak that has little to really do with the subject matter so you can provoke pointless debate over nothing.
and
IOW, you need to be intellectually dishonest because you don't have any real point to counter the post topic so you make them up in order to be able to argue with people you want to disagree with.
Funny how previous responses are perfectly applicable once again…
Methinks, thank you for the thoughtful and well reasoned response.
I suspect that we are arguing for the same thing from different perspectives.
From my perspective this is all misdirection from the root problem. We're here debating how to treat a symptom. Whether the Fed offers investment banks access to the discount window or not will do nothing to solve the problem because either way, offering the liquidity or letting them fail, we are simply treating symptoms.
The root problem is cheap money and all the distortions it creates which ultimately leave us with gross misallocation of capital resources and the severe market corrects which result. If the Fed isn't going to control the value of money in a reasonable manner then they need to be there to clean up the mess they create.
But the real solution is for them to control the value of money in a responsible manner such that inflation remains low and flat. Such that false signals of demand are not sent through the economy. Such that people can save in lower risk securities rather than being pushed into riskier investments because of negative real interest rates.
But the real solution is for them to control the value of money in a responsible manner such that inflation remains low and flat.
That's what Milton Friedman advised for a long time till he realized that expecting responsible behavior from 'them' was futile.
I agree with that.
Marcus,
I started writing a response but I don't think I can respond properly until you qualify somethings. I don't actually agree that cheap money is the root of all evil nor does the Fed control the interest rate (if that's what you're getting at).
Please define "cheap money" (this is a relative term) and what you think causes cheap money. Because, there's more than one way to get to cheap money and the only remedy for some cheap money is more regulation.
Methinks,
Because, there's more than one way to get to cheap money and the only remedy for some cheap money is more regulation.
Who are you going to regulate? The Fed drives cheap money with the low rates it charges to banks to keep the good times looking like there still going.
There's no need to control anything other than the interest rates which drive lending. Banks respond to the bait.
In a sense, one could say that the Fed is doing all the "regulating" with the money supply. To me it's nothing more than a price control that doesn't reflect real market conditions. Interest rates NEED to be be able to adjust to market forces somehow, some way…just like prices. Of course, if I had the answer to that, I'd be in Sweden getting a Nobel Prize. But in the meantime, something that makes the going rate more than a whim is needed.
Shughart ends his article like this:
"So, in addition to substantial growth in the federal bureaucracy, one likely "unintended consequence" of the Treasury's regulatory reform plan is greater consolidation of the financial services industry, creating more institutions too big to be allowed to fail and further erosion of the discipline essential to the operation of competitive markets."
There you go: he put "unintended consequences" in quotes! Which means what? That he really doesn't think they're so unintended after all. The quest will always be the same: bigger and more powerful government. And once you get to a tipping point, you do get a new type of power, of a different genus, if you will (as Hayek noted in the Road). More virulent and pumped, it will chew away at all competition and leave us with fewer and fewer choices. When there is nowhere else to run we will all sheepishly wonder from whence cometh this brave new world.
(I feel sort of vindicated by the last comment I posted on this subject, on the first Shughart article…)
John V,
Who are you going to regulate?
Not "who" but "what". The answer: spreads. The interest rate at which money is borrowed is the risk free rate plus a spread. Regulators can set floors and caps on those spreads. Price controls on money. That's what I meant.
The Fed drives cheap money with the low rates it charges to banks to keep the good times looking like there still going. There's no need to control anything other than the interest rates which drive lending. Banks respond to the bait.
John, you focus on low rates but the rate at which the Fed lends to member banks is only one tool to manipulate the interest rate (you call it price controls, and I call it market manipulation – either way, it's central planning). There is absolutely a way to allow the market to set the rates on its own – don't allow a central bank to centrally plan interest rates. It's too obvious for a Nobel Prize (although the Goracle got one for utter BS, so who knows). People are perfectly capable of deciding how much they're willing to borrow and lend, for what period of time and at what interest rate without Big Brother Bernanke dictating to them.
We can go round and round with the Fed thing all day. The fact is, the very existence of the Fed changes behaviour – as does the government and its past bailouts. so, it's difficult to determine how much of any outcome is attributable to any one factor, including the Fed. The real problem is the central planning of the central bank.
One surprising thing about recent events is that the recent Fed actions haven't had their historical effect. Coincidentally, I stumbled on this article by Robert P. Murphy just today. It's an interesting read and very topical.
Don't me wrong, Methinks
Much of what you are saying behind my post above.
I don't believe the Fed is good at doing what it does any more than I believe the Soviet planners were good at what they did. They just can't be.
I have read a bit on alternatives like free banking and I think it's worth a shot.
It's too obvious for a Nobel Prize (although the Goracle got one for utter BS, so who knows).
They've devalued the Nobel prize.
I think 'cheap money' refers to any monies created, by the government obviously, as a substitute for raising taxes such that the money loses value.
I figured we were probably on different parts of the same page, John.
Sam,
I'm not sure what you mean by: "I think 'cheap money' refers to any monies created, by the government obviously, as a substitute for raising taxes such that the money loses value." would you mind clarifying that?
Well apparently you missed vidyohs post then J.V.? He complained that as long as there is paper money, bank and government will use it the system to their own ends. Perhaps you missed vidyohs' posts on other thread where he believes that it's supposed to be the law that the U.S. Government is only allowed to make money from gold and silver coinage (which I doubt). But noooooo. You and Methinks go down the perfectly Libertarian path of 'if only the right regulations and right people were in charge'. Dickhead.
"…Libertarian path of 'if only the right regulations and right people were in charge'." – Gil
I'm not sure I've ever heard a libertarian (or Libertarian) argue that things would be better 'if only the right regulations and right people were in charge'. In fact that sounds a whole lot like the argument our dearly-departed Duck used to make on a regular basis.
The libertarian argument is: remove all (or most) regulations and then it really won't matter who is in charge. If you have a particular example of Methinks (or John V) advocating regulation and lamenting, "if only the right people were in charge", please share it with me because I missed it.
I'm supposing that's what marcus is talking about in regard to 'cheap money'. In essence, a policy of monetary inflation makes the money 'cheaper'. Money created without a causal link to production.
It used to be that introducing money into the system…back in the precious metal days…took some effort. It had to be prospected, dug up, separated, and coined, a lot of work, and the relative scarcity of precious metals made 'inflation' unheard of.
Paper money is a lot easier and when the politicians find that raising taxes can cost them an election, they simply print some more paper and blame business for the resulting apparent price increases.
Cheap money.
I started writing a response but I don't think I can respond properly until you qualify somethings. I don't actually agree that cheap money is the root of all evil nor does the Fed control the interest rate (if that's what you're getting at).
– Posted by: Methinks | Apr 17, 2008 4:05:56 PM
I understand the Fed does not directly control interest rates. But that is rather moot as the Fed certainly has the power to influence rates to be where they want.
You can watch short term interest rates of securities of all kinds move with the Fed's change in their targeted Federal Funds rate. A year ago money markets paid over 5% and now they pay less than 3%. The drop in those yields followed (not led) the Fed's movement of the Federal Funds target.
One way to interpret that is thusly: banks and businesses have less of a need for my money because they have a cheaper source and as such, I have to accept a lesser yield to compete.
Now, when the 'cheaper source' is another private party offering up their hard earned capital for less, that's all fine and dandy. But that's not the case now nor was it the case in the beginning of the 2000's when the Fed dropped rates to historic lows.
One way to interpret that is thusly: banks and businesses have less of a need for my money because they have a cheaper source and as such, I have to accept a lesser yield to compete.
– Posted by: Marcus | Apr 18, 2008 8:50:05 AM
Extending my comment above…
I can accept a lower yield OR I can move into higher yielding but riskier securities. And it is in this manner in which the Fed uses monetary policy as a whip.
Fallacy 1: Highly paid Wall Street investment bankers are smart.
Fallacy 2: Being smart has something to do with foreseeing risk.
Fallacy 3: Risk is foreseeable.
Fallacy 4: Wall Street investment bankers care about risk any more than a craps shooter.
Fallacy 5: Insofar as Wall Street investment bankers think rationally about risk, they're meaningfully distinguishable from a regulatory agency.
The economist's question is very reasonable, and the implied answer seems correct. A regulatory agency can do no better. The begged question is: Do smart, highly paid Wall Street investment bankers contribute to the success of an enterprise in proportion to their high pay or do some large crap shoots pay off while others don't with no? If we can't expect a regulatory agency to do so, why expect highly paid Wall Street investment bankers to do so?
The crap shoots may well be necessary, but is it possible for anyone anywhere ever to pick the winners in advance with more than an inevitably ill-informed guess that's likely to be unprofitable? If so, why pay Wall Street investment bankers highly? Why not investors organizing means profitably without earning a proportion of the profit, as with a progressive consumption tax? Why not more, smaller bets placed by more common players? Why entitle a few people to great consumption just because some large bets can be expected to pay off for someone?
Well, see, the finance industry is highly regulated, isn't it? I venture to suggest that Wall Street is an interface between the government and the investment industry.
gil,
Is someone frustrated because he/she has nothing to add?
See again my quote about looking for argument with nothing thoughtful to say.
Marcus, thank you for that clarification. I rather enjoy "talking" to you. I always learn something or I'm forced to think about a subject in a different way.
I understand the Fed does not directly control interest rates. But that is rather moot as the Fed certainly has the power to influence rates to be where they want. – Marcus
Certainly. If banks don't lend to each other at the target rate, the Fed can engage in open market operations and term it facilities auctions. If that doesn't work, it can launch a public campaign to reduce the stigma of borrowing directly from the Fed. If a private party were engaged in this kind of market manipulation, it would be completely illegal, but the Fed manipulating the market is A-okay. It's disgusting. I agree with you.
I think I understand what you mean by root problem now: 1.) we have a Fed and 2.) the Fed's specific mandate – by any other name – is to manipulate markets. Am I correct?
I also agree that if the Fed drives down the short term rate to below inflation, people are forced into higher risk, higher return investments – whether it's longer maturity bonds or stocks.
However, the Fed is not the whole interest rate story either. The Fed (to Greenspan's endless annoyance) could not control long term rates. In addition, credit spreads were tightening across maturities and across credit quality before the Fed lowered rates in 2002. There was a willingness among market participants to discount risk to (what I think are) ridiculous levels and accept much less compensation for risk than they traditionally have. That would be, as you put it, "another private party offering up their hard earned capital for less".
Thus, I can't completely agree that what's happening is not, at least in part, people just offering up their own capital at a lower price. It's not all Fed driven.
Of course, there might be an argument that the Fed's lowering of interest rates encourages more borrowing in general and forces lenders into unnaturally fierce competition. That wouldn't necessarily explain the tightening of credit spreads before the Fed lowered rates in the early 2000's, though. So, that component of cheap money was market driven.
Martin,
I completely agree with your list of fallacies (especially fallacy #1). I also agree that a lot of people on Wall Street are not worth what they're paid. But, I'm not the one paying them and it's not my business to dictate to the private individuals who are.
You're over focused on investment bankers and you assign to them a job they don't have on Wall Street (although, Shughart makes the same mistake). You both may just be talking about investment banks in general but it's worth taking a look at the various incentives on Wall street. Investment bankers are not paid to shoot craps. Some but not all Traders are. As far as I can tell, investment bankers are paid to convince not so bright company management to do mostly wealth destructive deals for a fee. Their individual compensation is loosely based on how well the bank does as a whole, how many good deals they can take credit for, how many bad deals they can blame on their subordinates and how well they can identify the right ass to kiss and how subtly they can kiss it. But they do all this in really pretty suits.
Traders in investment banks are loosely paid based on how well the bank does as well as their own P&L. Depending on how big their team is, they may be able to play the same political games as investment bankers at comp time.
Proprietary trading concerns on Wall Street eat what they kill. Hedge funds also, but to a lesser extent as they're able to soak their investors for fees.
There is a lot of incentive to take massive beta risk (unhedged long or short positions) and hope for the best. If you blow up, it's not your money and if you win, you get a huge cut. But good traders and portfolio managers hedge their beta risk and actually generate alpha (there aren't a lot of those). No matter how smart you are, you cannot know the future. The only think you really have control over is the amount of risk that you take. Smart investment banks, investors in hedge funds and prop shops ask a smart question: why should I pay more for a higher return if the risk taken to get that return is also proportionately higher? A smart investor looks at risk adjusted returns. There aren't a lot of smart investors (if there were, there would be a lot fewer hedge funds).
Marcus, thank you for that clarification. I rather enjoy "talking" to you. I always learn something or I'm forced to think about a subject in a different way.
– Posted by: Methinks | Apr 18, 2008 12:40:24 PM
Thank you, I really appreciate that. I highly respect your opinion and have found this discussion to be invigorating. Thanks.
However, the Fed is not the whole interest rate story either. The Fed (to Greenspan's endless annoyance) could not control long term rates. In addition, credit spreads were tightening across maturities and across credit quality before the Fed lowered rates in 2002.
Do you have data to support that? The Fed began lowering rates in 2000 and by the end of 2001 the Federal Fund rate was at 1.75%.
Here's my hypothesis:
By the early 2000's SIVs and CDOs became far more accepted in the financial industry. When the Fed lowered rates to historic lows something they didn't anticipate happened. SIV's and CDO's funneled billions of dollars worth of short-term cash into long-term bonds for the very reasons I've stated earlier. Low yields pushed investors into riskier securities.
This demand for long-term bonds is the false signal of demand I am referring to. Seeing the demand, mortgage companies appear to be the industry that innovated solutions to meet that demand. And, well, we know what followed.
Eventually, the Fed raised rates and the signal vanished. Shear momentum kept the the pyramid scheme running for awhile but eventually it collapsed leaving a whole lot of people who were just following price signals holding the bag.
I am very interested to hear your comments on that chain of events.
Do you have data to support that? The Fed began lowering rates in 2000 and by the end of 2001 the Federal Fund rate was at 1.75%.
Marcus, I'm sure really good data is available somewhere. I just don't know where as fixed income research is not my primary occupation. I think it would be quite a big project as spread tightening was a worldwide phenomenon.
That said, these are some pretty good graphs. Unfortunately, it would be nice to have data from before 1999 to at least 2007, but this will have to do for now.
Fed Funds Rate graph
Note that credit spreads were very low in 1999 (when the Fed Funds rate was around 5.00-5.75%). They widened in response to the bursting of the dot com bubble and 9/11 (as the Fed cut the Fed Funds rate from above 6% to below 2%, although they were still pretty low). Credit spreads began to tighten again in the beginning of '03. The graph ends in '04 but spreads continued to tighten, reaching historically low levels in mid-2007 – roughly three years after the Fed began to increase short term interest rates again.
I don't disagree that the curve trade you describe in your hypothesis at least partially explains what happened – especially since that curve trade is the basic business model of a bank. I disagree that the Fed was entirely responsible for what happened. BTW, I hope you appreciate that you've hit upon a very deep and complex issue here. My only hope is to add to the discussion, not to figure out what happened – they might be forced to give me the Nobel Prize if I figure it out
There are some things to note in thinking about this. Historically, the supply of short term lenders has outstripped demand for short term borrowing and continued to do so until the default rate at the long end increased and short term creditors cut off the spigot. Did the fed's lowering of interest rate have an effect on demand for short term credit? It must have. Did the Fed's subsequent increase of the short term rates have an effect on default rates at the long end of the curve? I'm not sure it did because the Fed can't control long term maturities (as Greenspan so often lamented). The more likely explanation is that looser lending standards (particularly lending to people without checking to see if they actually had a job) lead to higher default rates.
So, historically, there has always been an almost unlimited supply of short term creditors – much more supply of ST credit than demand for it. The curve trade is a money making proposition as long as the short rates are lower than the long rates. A Fed rate cut would steepen the curve, all else held constant. This would make the curve trade that much more attractive. We know that the spreads at the short end tightened much less than the spreads at the long end, flattening the curve. This could very well be because, institutions took advantage of the enormous supply of ST credit to lend long. A jump in supply of long maturity lenders, drove down the credit spreads for those maturities. In their competition for borrowers, they not only decreased the rate at which they were willing to lend but also who they were willing to lend to. You see the obvious problem with this. Suddenly, they were lending to people who had no chance of paying them back and defaults rose (remember that people whose interest rate had not yet adjusted began defaulting because they were given a mortgage they couldn't handle at any interest rate). As defaults rose, short term lenders became worried that the collateral they were lending against wasn't very good and they cut off the credit spigot. They demanded higher credit spreads and the curve flattened further, so the trade became less profitable. How much did the Fed effect that? The Fed did not flatten the curve by lending at the long end of the curve to anything that had a pulse. The Fed is not responsible for the almost endless supply of short term creditors. I completely agree that the Fed always exacerbates the problem by interfering in the market. The Fed definitely contributed to further curve flattening toward the end by driving up ST interest rates. But I can't agree that it solely responsible for what happened, as you imply in your hypothesis. I specifically disagree with the part of your hypothesis that attributes mortgage defaults to the increase in the Fed Funds rate.
Here's what I wonder: given that short term credit was always so available, why the sudden interest in the carry trade? I suspect that part of the answer is that so much wealth was created worldwide in the 1990's, that it was difficult to find investments – especially after the dot com bubble burst. The sudden jump in demand for the curve trade may be a result of capital looking for an investment.
Methinks, that is an absolutely brilliant post. Thank you.
While I take some time to digest everything you have written have a couple of comments and a particular point I'd like to clear up.
I'm not blaming the Fed for defaults on mortgages any more than I'd blame a person who's holding on to a money market which underneath has purchased some holding of mortgage back securities.
The more likely explanation is that looser lending standards (particularly lending to people without checking to see if they actually had a job) lead to higher default rates.
This is what am getting out when I mentioned the mortgage industry innovated new solutions to meet demand. They recognized that requiring a 20 percent down payment was never going to produce enough mortgages to meet the huge demand for mortgage backed securities (MBS). So they innovated new types of loans (ARM's) and new lending standards (such as mortgage insurance to lower down payment requirements). Some of this was good. Some of it, as we know, was bad and downright fraudulent.
But again, if we take a step back I think we'll see that the mortgage companies were simply responding to demand. Demand for MBS. They were trying to meet that demand. So while some of what they did may have been unscrupulous, I don't see how we can pin them as the source of the problem. We have to follow the source of the demand to get to that.
Also, I'd like to mention that we already had an excellent discussion of the role speculators played in all this. Still, speculation only works when the cost of money is less than the anticipated return on assets which puts us right back to looking for the source of the demand for MBS.
Here's what I wonder: given that short term credit was always so available, why the sudden interest in the carry trade? I suspect that part of the answer is that so much wealth was created worldwide in the 1990's, that it was difficult to find investments – especially after the dot com bubble burst. The sudden jump in demand for the curve trade may be a result of capital looking for an investment.
Wow. That is a fantastically insightful observation.
Yet, it begs the question. If there was so much money looking for a home then why did the Fed have to lower the Federal Funds rate so much? If we go back to incentives, perhaps the purpose was to lower yields to the point that it pushed this money back up into riskier investments.
I'm going to contemplate on the rest for awhile. Thanks again.
See how cool this blog is when it’s not so cluttered?
Methinks (who is brilliant):
Here's what I wonder: given that short term credit was always so available, why the sudden interest in the carry trade? I suspect that part of the answer is that so much wealth was created worldwide in the 1990's, that it was difficult to find investments – especially after the dot com bubble burst.
And here’s (part of) the answer:
The carry trade was basically an arb run to outperform US Treasuries for (more or less) idle cash.
That, in turn, begs the question(s), what is the true risk free rate? And how is this reflected (is it reflected?) accurately in relative currency rates/interest rate arbitrage?
Gracias, Marcus. As usual, you raise difficult questions – just in case you decide to check back here some time this weekend and I don't have time to post later:
Yet, it begs the question. If there was so much money looking for a home then why did the Fed have to lower the Federal Funds rate so much?
You're asking for a reason and all the Fed can ever offer you is an excuse for its behaviour! Dropping the short term rates suddenly steepens the curve and makes the carry trade more profitable and the reason the Fed does that is to bail out monkeys who got in too deep and took on too much risk. There's what I think is the reason. The horrible shock to the economy caused by the dot com bubble bursting, a "low" (read: fictitious) inflation rate, and the attacks of 9/11 were the excuses the Fed used to drop short term rates. Who knows? Maybe the Fed didn't want to seem as if it were doing nothing as people "reeled" from these "crisis". My answer to your excellent question is: the didn't have to lower the Fed Funds rate that much at all. Just my opinion.
But again, if we take a step back I think we'll see that the mortgage companies were simply responding to demand. Demand for MBS.
Right – keeping in mind that what I call supply of lenders you're calling demand for MBS.
So while some of what they did may have been unscrupulous, I don't see how we can pin them as the source of the problem.
I'm not sure I would necessarily call it "unscrupulous", I prefer to call it "stupid". To the extent that they decided to compete in this market as the risk increased relative to return, I think mortgage companies can be blamed for that decision. But, obviously, I agree that they are not solely responsible for the free for all. Also, I'm not sure that there is one source for this problem and I'm not sure if we'll ever be able to identify all the sources. But you and I have given it a good try here.
Still, speculation only works when the cost of money is less than the anticipated return on assets…
Ah! But that's what we've been talking about, isn't it? The returns were positive (the curve was not completely flat) – the risk they were taking to get those returns was way out of proportion to the actual realized returns. And I assure you, they DID anticipate positive returns on the assets. That's why they lent (bought the loans). You rightly call it speculation. However, they didn't think it was speculation. They thought it was (and I quote more than one hedge fund manager here) "like cash" (I kid you not). They completely under-priced risk. Actually, I think the credit spread link I provided was to an analyst report and, upon skimming it, you'll find that the thinking was that risk was fairly priced – as spreads were tanking. That was pretty common thinking back then.
I'm not blaming the Fed for defaults on mortgages any more than I'd blame a person who's holding on to a money market which underneath has purchased some holding of mortgage back securities.
I didn't mean "blame" in that sense. I meant that I didn't agree that the Fed raising interest rates lead to defaults (which is what I assumed you meant by "people left holding the bag).
Also, while I'm sure that some people were pushed out of short maturity lending because of interest rates that came close to historical lows, that effect was probably insignificant. This is because the supply of short maturities has always been so huge and it didn't diminish to any noticeable extent as rates dropped. Perhaps some private individuals sought a higher interest rate, but private individuals are a drop in the bucket. The overwhelming majority of demand for short term paper comes from institutions that need to park money for a very short period of time. A mutual fund's cash reserves, a hedge fund's cash reserves, an investment bank's short term cash reserves, for instance. The money may be deployed (either returned to investors or used to purchase assets) in 30 days, so liquidity is essential, but the company still wants to earn interest.
The demand for MBS was also not directly driven by individual investors. That demand came from institutions that did the carry trade we've been discussing. Of course, some investors were invested in funds engaged in this sort of thing, so there was indirect demand.
One of the questions we will never be able to answer but is interesting to think about is: If the Fed had not dropped the interest rate, would risk seeking behaviour have spiked anyway? I think it probably would have because the collapse of the stock market bubble lowered returns sharply but expectations of future returns were slower to adjust. In response, money managers took greater risks to augment returns. That's my guess.
I've had a great time talking to you about this. Than you. I'm going to be working all weekend but I do hope we get a chance to talk about this again at some point in the future. I'll check back later in case you decide to write a response to this post after all. Have a great weekend.
Outstanding, Methinks.
Again.
Aren't you paying them? Much of the cash in their accounts flows from a central bank trading in rights to collect taxes from you. Even ignoring Bear Sterns' now direct access to the discount window, much credit it extends has always come indirectly from the central bank, and it also holds Treasury notes that are nothing but claims on tax revenue. Bear Sterns managers receive bonuses they "invest" in Treasury notes, and on and on. How do you know how much of it you're paying?
Do you write the POTUS' pension check? Does this cash become "private" and thus none of your business as soon as the Congress decrees it "private property" of a former President? How about the rest of the Federal workforce and contractors and Treasury note holders?
The total value of all Treasury securities rivals the total market capitalization of the S&P 500 companies. Labeling much of this entitlement "private" creates a loophole in state authority large enough for any herd of elephants. How many transactions away from some state expenditure (or some expenditure financed by central bank credit) is your paycheck? You probably don't know. I don't know either.
I focus on fallacies that Shugart seems to presume, but maybe his reference to "smart investment bankers" is sarcastic.
Actually, they are. They must shoot craps, because credit and investment in a free capital market can only be a crap shoot. This assertion is no indictment of free capital markets. I'm not disparaging the craps shooters. The crap shoots are not a bad thing, and being smart is not completely irrelevant. Knowing that seven is the most likely outcome of throwing two dice is useful when placing bets, but it's still a crap shoot, and you likely bet against people who also know the odds. If what can be known of risk is widely known and already reflected in asset prices, the knowledge has little marginal value.
I agree, and I don't see how the bankers can be brighter than the company management receiving the bankers' credit, and I don't see how the high level managers receiving the credit direcly can be brighter than the lower level managers directing real resources, and I don't see how the lower level managers can be brighter than the resources they direct, and I don't see how the resources they direct can be brighter than the customers they serve. That's the problem with too much hierarchical authority. Maybe the layers of authority are supposed to ensure that everyone makes smarter (by the book) decisions, but all they can really do is skim the flow of entitlements.
And they have MBAs from Harvard or Yale, like all of the Bush cabinet members. Unlike Bush, they even have top grade point averages. Unfortunately, these credentials signal no information relevant to the decisions they make. Being "smart" in this context is not a matter of repeating sequences in reverse or recognizing a rotated shape. "General intelligence" is no substitute for specific information. Generals are paid more than Privates (who are now called "Specialists") because a system of titular authority entitles them to higher pay, not because General decisions are actually more valuable.
Making a General's decisions badly can be very costly, but the high cost of a bad decision implies nothing about the utility of "being smart" in making a better decision. Making a better decision may fundamentally be a matter of chance regardless of the cost of making a bad one. If intelligence makes a better decision possible, I expect this intelligence to be worth little to most investors in capital markets. General smarts can be bought, so masters of money will buy it, and I therefore expect asset prices to reflect any truly valuable information very quickly. In other words, capital markets are efficient.
If billions ride on the toss of a coin, we could pay people millions to call the outcome, and some people would then call correctly and earn the millions. These people add no corresponding value to the game, but they are entitled to consume commensurately. Costly decisions don't imply that people deciding correctly add corresponding value. If we toss a second coin to call the outcome of the first and pay the second coin nothing, we can expect do as well.
And of course, people paid to make Important Decisions will create Important Decisions for themselves to make, as when the Bushtapo creates the War in Iraq.
Right. And you can receive a commission even if you blow up. This accumulation of entitlements regardless of the outcome of speculative investment is inflationary. Unwinding the bad investment does not eliminate persistent entitlements reflecting no added value. Suppose I write a hundred mortgages, lending people the price of a hundred properties. I own these properties myself, and I make a profit on the sales, and I also earn fees writing the mortgages in the first place and then selling them as a package to a larger investor.
The borrowers eventually default and their properties don't sell for what they owe, but I have Treasury notes I've purchased with the cash, so I have an endless stream of cash from taxpayers. Furthermore, the price of the mortgage securities I sold came ultimately from central banks. Some bankers borrowed it from the central bank first, and they lose in the transaction in theory, but I don't care, because I'm not holding the hot potato when the clock runs out and the entitlment game is over.
In this scenario, I sound like a swindler. In reality, a hundred different people sell these houses, and many lenders with no relationship to the sellers write the mortgages and package them into a few mortgage securities, and a few banks buuy the securities. This scenario is actually worse, because hundreds of people possess the persistent entitlement to consume reflecting no value produced. Inflation is increasing entitlement to consume without corresponding production, and these hundreds of people will more likely consume, i.e. they'll bid for more common goods.
In the swindler scenario, where I accumulate a large chunk of cash, I'll more likely reinvest it. If I reinvest it speculatively to employ idle factors, I might even do some good this way. If I employ the new debtors well enough to enable them to pay their mortgages, I even prevent the defaults. Alternatively, I could buy Treasury notes or existing commercial real estate or something similar. I can be a consumer, or I can be an investor, or I can be rent seeker. Because our population is aging rapidly, the proportion of rent seekers is increasing.
Knowing that the risk is higher is knowing the future, so smart investment bankers can ask this question in general terms, but they can't answer it specifically. Were mortgage backed securities high risk or low risk? Precisely what number between zero and one should I assign to the promised yield of one of these securities? What is the statisticial distribution of these yields? What's the variance of the distribution? Does the distribution even have a well defined variance or is it "fat tailed"? Do securities from Bear Stearns offer yields distributed like securities from other banks? Investment bankers apparently didn't know. Shares of the bank traded for seventy dollars one week and two dollars the next.
You can't control for risk you don't know, and a Phd. in statistics or economics or finance (or all three) tells you next to nothing about these risks. These days, a Phd. in economics should tell you that you can't know, because a doctor of economics should understand market efficiency.
There aren't a lot of smart investors in this sense, because these smart investors can't exist, but people can strike it rich with hedge funds, just as people can strike it rich in casinos, and the funds can serve a useful purpose. Markets are not inevitably efficient. Competitive, free markets become efficient. Ironically, a more efficient market is riskier than a less efficient market, precisely because prices reflect rational assessments of value.
If you want to buy low and sell high, you want irrational prices. In an ideally rational market, you're always trying rationally to buy low from someone trying rationally to sell high. You can only bet that you know a bit more than the seller on the margin, and you also bet that other buyers with this bit of information don't outbid you.
If you want to buy low and sell high, you want irrational prices. In an ideally rational market, you're always trying rationally to buy low from someone trying rationally to sell high. You can only bet that you know a bit more than the seller on the margin, and you also bet that other buyers with this bit of information don't outbid you.
– Posted by: Martin Brock | Apr 19, 2008 12:54:46 PM
This is an over simplification. While in the short run this may actually be a reasonable description of day-traders and speculators it falls woefully short of describing the market in the long run.
In the long run the market represents the ever growing tide of wealth. The only thing one needs to do to get a boat to ride that tide up is buy an index fund.
If you want to buy low and sell high, you want irrational prices. In an ideally rational market, you're always trying rationally to buy low from someone trying rationally to sell high. You can only bet that you know a bit more than the seller on the margin, and you also bet that other buyers with this bit of information don't outbid you.
– Posted by: Martin Brock | Apr 19, 2008 12:54:46 PM
Another way this is over simplified is that it presumes the only reason I might sell a security is because I think it's going to lose. That is false.
There are endless reasons why I might sell which all have to do with opportunity costs. Perhaps I simply want to buy a new car. Or, I'm selling to pay for my retirement. Or, I think I have a better opportunity some where else in the market and have to sell some of my holdings to move into. Or, I'm rebalancing my portfolio to control risks.
None of these reasons have anything to do with the zero-sum game you're trying to turn it into.
Your indictment of my simplification is a simplification. I have no idea what "the market in the long run" is supposed to mean here.
The price of a share in an index fund is subject to market efficiency as much as the price of an individual company. I don't expect the central limit theorem to apply to a distribution of yields in an efficient capital market. I don't expect the average of many yields to have a narrower distribution than a single yield. Sure, an index fund rises with the tide, but insofar as this rise is predictable, the current price of the index reflects the expected rise as much as the current price of a share of Google reflects expectations of Google's growth.
I discussed an "ideally rational market", a theoretical abstraction. I understand that reality is not this ideal.
Yes, you could sell for any of these reasons, but in an ideally rational market, you're still timing your sale to maximize your profit insofar as you're able. If you don't like the timing, you'll buy your car on credit and sell later.
I haven't said a word about any zero sum game, and I don't believe the game is zero sum.
Methinks,
The discussion of spreads and the yield curve is interesting, but does it matter at all what the creditors finance specifically? Is it all about borrowing short vs. borrowing long rather than, say, borrowing to bury fiber optical cables vs. coaxial cables or borrowing to fill a web server farm with Linux servers rather than Windows servers or borrowing to plant corn vs. soy beans? Are general financial abstractions all we need to know? Or is this belief the problem?
I discussed an "ideally rational market", a theoretical abstraction. I understand that reality is not this ideal.
– Posted by: Martin Brock | Apr 19, 2008 4:05:53 PM
OK, then perhaps I don't understand your point.
Stock price is a weighted average of a diverse set of people ranging from those who are only going to hold the stock for a few minutes to those who are going to hold it for decades.
On the one hand you may have a day-trader short-selling because he thinks the price is going to drop tomorrow while on the other hand a long-term holder is buying because he thinks 20 years from now it'll be worth more than he's paying today.
Who's right? Maybe both.
To me, that seems to poke a little hole in your argument, "You can only bet that you know a bit more than the seller on the margin."
People buy and sell for different reasons. They have different goals and different opportunity costs.
Yes, you could sell for any of these reasons, but in an ideally rational market, you're still timing your sale to maximize your profit insofar as you're able. If you don't like the timing, you'll buy your car on credit and sell later.
Which is just a long winded way of saying I weigh my opportunity costs. But my opportunity costs are MY opportunity costs. They are different than what someone else's opportunity costs are which means I might be selling a stock while someone else is buying and it be perfectly rational for both of us.
If the "long term holder" knows that the price will drop tomorrow, he's still better off selling today and buying again tomorrow, assuming the spread covers the transaction costs. If it's really possible to profit this way, the "long term holder" will pay day traders to trade for him over the long term.
I don't think so. If you're holding an index fund rather than some day trader's fund, you're betting that day traders can't do better than a buy and hold the index strategy.
A particular day trader may possess very unique information about the value of an asset, information that professional fund managers generally could not know, and this particular trader could profit from this information. That's fine. That's how markets become efficient in the first place. That's the irony of market efficiency.
I don't at all believe that no trader ever has information relevant to the price of an asset that isn't already reflected in the price, but I am willing to bet that you don't have much of this information, and my bet applies to the price of a share an index fund as much as it applies to the price of a share of Google or Bear Stearns. Some trader somewhere at some time always knows something before everyone else. It's just very unlikely that you're one of these traders right now.
Of course. Market efficiency says that you can't really make a "smart" choice of one asset over another based on an expectation of a higher yield, not based on public information anyway. If you could, the price would rise until the yield is not higher, precisely because the information is public, and our free, competitive markets react to public information quickly. Market efficiency doesn't say that you never have a reason to buy or sell assets, and it doesn't say that you can't make money buying and selling, but when you buy, you can't much distinguish one asset from another in terms of its expected yield.
If you're holding an index fund rather than some day trader's fund, you're betting that day traders can't do better than a buy and hold the index strategy.
– Posted by: Martin Brock | Apr 19, 2008 5:34:55 PM
To be more precise, I'm betting I cannot in advance pick which day-trader will out perform the index. In fact, I personally purchase index funds because I recognize that I hold no special power of picking winning fund managers in advance.
An index fund which tracks the S&P 500 or, even better, a total stock market index fund returns the average investor's return. For everyone who out-performs the market there is someone who has under-performed the market. But when you take all of the returns of all investors and average them together you have the average investors return and that is what an index fund returns minus expenses. And speaking of expenses, many if not most of those who out-performed the market on paper still under performed the indexes after expenses.
A particular day trader may possess very unique information about the value of an asset, information that professional fund managers generally could not know, and this particular trader could profit from this information. That's fine. That's how markets become efficient in the first place. That's the irony of market efficiency.
I agree but don't really see the irony. For index funds to work there MUST be people out there somewhere actually evaluating and putting a price on stocks. An index fund is a way of riding their coattails.
Of course. Market efficiency says that you can't really make a "smart" choice of one asset over another based on an expectation of a higher yield, not based on public information anyway. If you could, the price would rise until the yield is not higher, precisely because the information is public, and our free, competitive markets react to public information quickly. Market efficiency doesn't say that you never have a reason to buy or sell assets, and it doesn't say that you can't make money buying and selling, but when you buy, you can't much distinguish one asset from another in terms of its expected yield.
I think we largely agree.
Interesting discussion, and this is my first post here.
I am in the camp that says this is a hand waved concern, for nothing was decided about how the Fed can reorganize, and, given power, I can imagine ways that the Fed could solve the problem without regulatory enhancement.
Your statement is more precise and better put. Can you not pick winning fund managers in advance because of what you don't know or because of what they don't know? I suppose you don't know the answer to this question, and I'm very skeptical that the fund managers know the answer, but their investors must believe that they know.
If fund managers all flip coins similarly, some will win and some will lose. Then you can't pick the winners, because no one knows who'll win. Even the god of rationality doesn't know, because the god of chance picks the winners.
A particular fund manager on a particular day may reach the market with relevant information in time to profit from it, but the more he and other investors profit from the information, the less it is worth, because profiting from the information bids down its yield.
The yield of information needn't reach zero in this bidding. It reaches a background rate at which the particular investment strategy is not particularly attractive compared with other strategies. "Buy the market" (which typically means "buy an S&P 500 index fund") is not an exception to this rule. "Buying the market is better than buying a managed fund" is a bit of information that must be subject to the rule.
On the other hand, investors need not be rational. Some managed funds will outperform index funds. If your goal is to outperform or be damned, you'll defy the god of chance and buy a managed fund, and you'll probably be damned, but you might outperform. At a party of top performers, you don't find the damned, because they aren't invited.
An index fund is not an average of all investors. It's more like an average of all investments (large, public investments), which isn't quite the same. The S&P 500 index is an average of the 500 largest, publicly traded corporations weighted by market capitalization, so buying an S&P 500 index fund essentially buys shares of the 500 largest firms and buys more shares (in dollar terms) of the larger firms. It's essentially a bet that bigger firms are better investments but not quite a bet that the biggest is the best. After all, firms grow by profiting in a market of free investor/consumer/laborers, we hope. Or maybe bigger firms are better investments, because big government tends to favor big business, and we live in an era of big business.
If most investors don't follow the same index strategy, the average investor's portfolio doesn't track the index. If many investors do follow this strategy, they bid up the price of the index until the yield is more like the yield of other strategies. Even if bigger firms really are better firms, investors can and will bid up the price of bigger firms until their yield (or the yield of the cap-weighted index) is no better than other firms.
Of course, buying shares of an S&P 500 index fund isn't really buying the whole market. This fund doesn't invest in real estate at all, although it does invest in companies building houses or supplying resources to builders, and it doesn't invest in municipal bonds, although it does invest in companies contracting to municipalities. The S&P 500 companies represent roughly 80% of the equity of all publicly traded firms, but many firms are not publicly traded.
Maybe your best strategy ultimately is not to buy these shares at all but to reinvest your liquidity in furthering your own education to further your career, improving your own home, maintaining your car to maximize its resale value or investing in real estate or businesses in your own community.
The whole idea that "investment" describes an exchange of Federal Reserve Notes for a promise of more Federal Reserve Notes in the future is not my idea of "capitalism" at all. I don't know why anyone expects to profit this way, and I don't much believe that anyone should.
If you hand cash to a Wall Street financier and lose it all this way, I don't really care. If you exchange cash for Treasury notes that lose value to inflation, I care even less. In fact, I advocate this outcome. If it were up to me, the Federal government would default on all of its obligations today and never borrow another penny or coin one to spend again. Then it would be forced to raise taxes to finance its imperial ambitions. We'd still have banks creating money to extend credit, but they wouldn't extend any credit to the state, so "investors" would have no statutory entitlement to a yield.
You aren't coat-tailing all investors as much as you're coat-tailing the value added by all of the factors (or the value of their synergy) in the S&P 500 companies; however, you do compete with all investors to claim this yield, and as you compete with them, you drive the yield down until the difference between its value and the value of competing strategies is a crap shoot. Firms generate real profits, but capital markets bid up the price of more profitable firms and bid down the price of less profitable firms, so for most investors, more profitable firms do not yield more than less profitable firms.
If most investors don't follow the same index strategy, the average investor's portfolio doesn't track the index.
– Posted by: Martin Brock | Apr 20, 2008 7:22:12 AM
Good point. Before we can discuss the average investor's return we must define our market.
For example, if we define the stocks of the S&P 500 as our market then an S&P 500 index fund will be the average investor's return, within that market. Of course, most actively managed funds don't limit themselves to such a narrow market so it is hard to make direct comparisons. Many actively managed funds will tout how they 'beat the index' when in fact, they didn't stick to the market of stocks within the index.
"Buy the market" (which typically means "buy an S&P 500 index fund") is not an exception to this rule. "Buying the market is better than buying a managed fund" is a bit of information that must be subject to the rule.
An index can be said to be better than an actively managed fund because it will A) return the average investor's return, within that market, prior to expenses and B) has lower expenses. Actively managed funds have to pay for researchers and stock analysts, they also tend to trade alot so they have high transaction costs. Plus, all that active trading is likely to distribute more capital gains. All these expenses mean that the average return of all actively managed funds within a specified market will underperform the index after expenses.
So basically, since you can't predict in advance which fund will out perform the index before expenses then pick the fund with the lowest cost because that is something you CAN predict. An index fund will likely have the lowest costs.
If the "long term holder" knows that the price will drop tomorrow, he's still better off selling today and buying again tomorrow, assuming the spread covers the transaction costs. If it's really possible to profit this way, the "long term holder" will pay day traders to trade for him over the long term.
Sure, if s/he knows for an absolute certainty. Even then, though, s/he still pays transaction costs and triggers tax consequences.
That's how markets become efficient in the first place. That's the irony of market efficiency.
I thought that you've been arguing just the opposite…that markets are not efficient. Are we just chasing our equalibiriums here?
Some trader somewhere at some time always knows something before everyone else. It's just very unlikely that you're one of these traders right now.
A trader with access to the accounting books and has knowledge of the strategic plans of the company would have an edge as far as the timing of the information is conserned. Smart and active shareholders are supposed to be looking at these thing quarterly; and why not, they're owners. Most of us are passive owners and don't have much 'on the line' because the relatively limited anount we've got in equity, as individuals, is also diversified in many companies' securities. There's a cost to keeping oneself consuming information on quarterly filings…less time to make contributions on a blog is just one of those costs.
Market efficiency says that you can't really make a "smart" choice of one asset over another based on an expectation of a higher yield, not based on public information anyway.
Market effeciency just implies that given all participants 'in the market' for a security, that all of the knowledge, the financial leverage, the preferences sets, and the forecasting abilities of all those participants are baked into the price of the security from moment to moment [while the security is trading] and that the lag time between the decision to execute an order and the participants' paradigm on a security is probably less than a day in most cases.
Maybe your best strategy ultimately is not to buy these shares at all but to reinvest your liquidity in furthering your own education to further your career, improving your own home, maintaining your car to maximize its resale value or investing in real estate or businesses in your own community.
– Posted by: Martin Brock | Apr 20, 2008 7:22:12 AM
I don't think that there is really anything to disagree with here. It's all about opportunity costs based upon what you as an individual value.
The whole idea that "investment" describes an exchange of Federal Reserve Notes for a promise of more Federal Reserve Notes in the future is not my idea of "capitalism" at all. I don't know why anyone expects to profit this way, and I don't much believe that anyone should.
IMO opinion, I invest in businesses because businesses are the generators of wealth as we typically define it. As I stated earlier, an index fund is my boat to ride that ever rising tide of wealth.
Of course, as both of us have pointed out, nobody knows what the futures has in store. Black swan events can send the stock market down for many, many years. I personally am very concerned about the wave of protectionism sweeping the world. Not only am I concerned about the reduction of wealth generation that protectionism causes but I'm also concerned about the fact that protectionism is a road which historically leads to wars. Few things destroy wealth as effectively as war.
All that aside, the best defense we have against an unknown future is diversification. To me, that means a person who is loaded up heavily in stocks is not well diversified. There are many other kinds of assets which have low correlations to stocks that are worth adding to our portfolio and that certainly includes more than you can buy in a traditional investment account.
Absolute certainty isn't necessary, but the additional yield must justify the cost of necessary research and transactions.
I have consistently argued that markets are efficient.
We're chasing opportunties to profit from information relevant to the value of assets but not yet reflected in the price.
Right. I oppose "insider trading" laws that prohibit profiting from this type of information, because these laws inhibit market efficiency. I oppose most intellectual property for similar reasons. I instead favor a progressive consumption tax, so you may profit as much as you like however you like, but an obligation to reinvest profits limits your entitlement to consume. A progressive consumption tax of this type is a progressive income tax with steeply progressive marginal income tax rates combined with a tax-deferred, individual investment account (like an IRA) with unlimited contributions.