25 Jan 2016

Don’t Ask, Don’t Tell (DADT) was a (now repealed) US official policy that insisted that gays serving in the military must take part in a cover-up. On the grounds that they kept their sexual preferences a secret they were excused from being openly bullied, discriminated against and dismissed. Something that everyone knew to be untrue (the idea that the US military was staffed entirely by patriotic heterosexuals) was sanctioned in a big game of “let’s pretend”. If everyone acted as if it were true it would be just as if it were actually true.

But DADT turned out to be too convenient a device to be confined to such a narrow issue. It was perfect for the treatment of subprime mortgages! It was clear to many insiders that people who had no realistic chance of repaying were being granted loans to buy properties that had to rise in value to bail out the borrower, that these debts were being insured on terms that didn’t come close to reflecting their risk and that the loans were being repackaged and sold on, backed by credit agency ratings that were uninformed and irresponsible at best. Yet even when the crisis was unfolding at speed, banks and other financial institutions were saying publicly that everything with which they had been stuffed was AAA quality. Check out The Big Short for a great explanation of the story.

The trouble with DADT is that it is like a Ponzi scheme. Once you have started to pretend, you have to keep going. The morons working at the soon-to-be rescued banks did not mean to buy toxic junk. But once the mistake was made the easier option was to keep playing along. Like a trader who hides loss-making positions in the bottom drawer (or a secret computer file), the final thing you can try to buy is time. You literally decide to wait for a miracle.   

Something like this is going on with Quantitative Easing (QE = DADT). As I have pointed out elsewhere, the truth that QE was a device for inflating asset prices in order to save the banks from marking them to market was spun into an officially sanctioned untruth – that it is beneficial for the wider economy. Endless years of near-zero interest rates. How’s that working out for us?  

Here is a news story from last Friday:

“The European Central Bank published updated economic projections by external analysts that back the case for more stimulus.”

We are now eight years and counting into the financial crisis and the ECB and ‘external analysts’ (who or whatever they are) are colluding in the untruth that the ECB is executing a strategy of economic stimulation. Worried about China? Think commodity prices are dangerously low? Never fear, the European Central Bank is here.

“We’ve plenty of instruments,” the ECB president said on Friday at the World Economic Forum in Davos, Switzerland.   

For the record, the band on the Titanic had plenty of instruments and supposedly played “Nearer my God to thee” as the ship went down.

It is certainly true that Mario Draghi understands many important things that are beyond me but how many people believe that he is going to save the world? DADT.

I have mentioned China and Ponzi schemes and this leads naturally to the topic of Chinese GDP. Many people are very suspicious of Chinese GDP numbers. There are stories of the difficulty of collecting data from 31 provinces. There is the fact that the numbers come out very quickly: preliminary 2015 numbers were released on 18 January 2016: we are still waiting for the UK (28 January), the US (29 January), Germany (12 February) and Japan (15 February). And there is also the fact that, despite it being widely hailed as the saviour of the capitalist world, China has been ruled by the Communist party since 1949.

Here is a comment from David Pilling of the FT (16 September 2015)

Work by Harry Wu, an economist at The Conference Board, an independent research institute, concludes that, from 1978-2012, China grew at 7.2 per cent a year. While that is spectacularly fast, it is 2.6 percentage points below the official 9.8 per cent estimate.

Mr Wu finds that China overstates productivity growth and underestimates inflation, measured by something called the GDP deflator. If the deflator is understated, “real” growth, adjusted for inflation, will be overstated.

Mr Wu also finds that authorities exaggerate growth in bad times and play down the impact of external shocks. According to his estimates — which build on methods he helped develop with the late Angus Maddison — China grew at 4.7 per cent in 2008 versus the official estimate of 9.6 per cent and just 4.1 per cent in 2012 compared with an official 9.7 per cent.

You might read this and tut disapprovingly but then say, look, 7.2% a year is pretty good – anyone else would bite your arm off for 7.2%.

But then you would be forgetting the dangerous magic of compounding. Let us say, rounding up estimates, that the Chinese economy was worth $300bn in 1978. At 7.2% a year that $300bn had become $3200bn in 2012. At 9.8% it would be $7200bn, more than twice the size.  

As Bernie Madoff discovered, once you have rebased your numbers fraudulently, you just have to keep going. If you are in charge of Chinese GDP statistics and you are starting from a base that is double the actual figure, what do you do? Broadly, you have two choices. First you can say, as someone officially did, that growth slowed a little in 2015 from 7.3% to 6.8%. You will be gratified that financial experts from all over the world will pop up to say that they were expecting a slowdown but this was better than they feared. Your second choice would be to say that due to an accounting error GDP ticked down by 57.8%. Well, what would you do?

In many ways this is quite comic. DADT often is when pompous self-appointed experts say that they believe nonsense and advise everyone else to do the same. I will not name names but consider this:

“Discussions about the economic situation in China tend to feature a lot of hype. GDP growth for 2015 was estimated at 6.9%, a touch weaker than in 2014, but hardly a disaster,” said Someone, an economist at Something Asset Management.

Someone Else said that although he did not think there was another global recession on the horizon, he did have some concerns.

“There are significant risks. China now accounts for approximately 17% of global GDP; up from 10% in 2005. Any material slowdown in the second largest economy in the world would have significant ramifications for the rest of the globe,” he said.

And there is a key point. Are global businesses supposed to plan their capital investments on the universally agreed fact that China is 17% of the world economy? Just imagine if it turned out to be not 17% but 8%? There would probably be catastrophic over-investment in commodities that China was believed to need. These would include oil, copper, iron ore and coal. Could this be a clue as to why oil prices have fallen by 70%, copper by 55%, iron ore by 79% and coal by 61%? Many if not most of the world’s raw material producers are now experiencing financial stress. Let’s Pretend can be a very expensive game.

I have often pointed out that average people cannot afford to buy average houses in the UK. A tidy solution would be for house prices to fall. I think that’s how markets are supposed to work. But falling house prices would be political poison. So what do we do? Let’s pretend that the problem is that “we” are not building enough new residences. If the house building companies swallow this line again they will get into trouble again. They can’t be that stupid, can they? Don’t ask, don’t tell.

Here are some other examples. University graduates generally get better paid jobs than people without qualifications. So, if more and more people go to university……what happens?  I think I have the answer: the number of well-paying jobs grows! No. Just kidding. What happens is that graduates are offered positions for which degrees are not obviously necessary. Assistant Merchandiser at Matalan, anyone? Charity chugger? The trouble is that you might be competing with people who do not have £50,000 of student debt.

If you are a politician appearing in front of a television studio audience in the UK today and you want to collect little rounds of applause you will probably say: more people should have chance to go to university (clap clap), we need to build more houses (clap clap) so that more people can own their own homes (clap clap) and our banks need to lend more (clap clap).

If you took a more honest line and stated what is likely to be true; that many people waste their time and money taking degrees; that technology is eroding many jobs for which education was necessary; that demographics dictate that we need more nursing homes than family homes; that buying into the property market at current price levels is reckless and could easily lead to financial ruin; that our banks are still critically damaged and that expanding their balance sheets by lending at the lowest interest rates ever known to humanity does not sound smart; then you might find that something that sounds like “clap” would be poured over your head from a great height.

Never mind. It’s easier to be an investor than a politician. As investors, when we see that DADT has kicked in and that all around people are pretending that wanting something to be true and its being true are the same thing, then we can think of ways of taking advantage. Much of this will be by avoiding doing stuff. Don’t shame your children into going to university unless the reason for them doing so is clear or at minimum plausible. Don’t think that property ownership will be the key to your future financial security just because it worked for your parents and grandparents.

Oh, yes. And don’t own bank shares.

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