It is communly understood that markets are subject to "bubbles". Bubbles are consequential. When markets are irrational, people who behave irrationally, squander resources, and do foolish things may be handsomely remunerated, while people who act sensibly are punished. During bubbles, mountains are moved to create what should not be created, people devote years of their lives to developing skills for which there will be no good use, opportunities are lost and scarce resources are squandered. Estimating the costs of any particular bubble is impossible, because we can never guess what an economy would have done instead of the unproductive things that it did do. But it's obvious that the scale of malinvestments have often been vast.

There is a fuzzy line between legitimate enthusiasm and risk-taking and a destructive speculative bubble. Reasonable people can and do disagree. Nevertheless, I think any fair reading of economic history shows that speculative bubbles are frequent phenomena, which are often identified contemporaneously by market participants who find they have no way to profit from their correct, but disputed, judgement. So, these insights fail to be reflected in market prices, permitting bubbles to grow without restraint. This is the essence of Keynes' quote, and it is a remediable institutional failure that decades of much-hyped financial innovation has simply failed to remedy.

The structure of financial markets is systematically biased towards long positions, which reflect an expectation of price appreciation, and are biased against "shorts" who try to profit from expected depreciation. Why? Because a "long", someone who expects a company or composite to do well, can pay cash for a position, and not worry about the path by which the securities have purchased arrive at a rational evaluation. A "long" can ignore transient irrationalities in the path by which a security arrives at an expected price, and merely bet (correctly or incorrectly) that the expected price will be attained within a reasonable time-frame. This is the strategy that has made Warren Buffet rich. He scours the market for "50-cent dollars", buys them, and waits. If a stock "worth" a dollar drops from $0.50 to $0.25, or even to $0.01, Buffet, if he is confident of the security's intrinsic value, can just hold the stock, until eventually what is worth a dollar sells for a dollar. He can ride out transient market irrationality, and if he is correct in his valuation, he profits.

But what about the "5-dollar dollars" in a market? It is just as useful, from a resource allocation perspective, for investors to be able to profit from pointing out misallocations of capital as it is for them to remedy underallocation. But an anti-Buffet, who is as confident and correct as Buffet in his valuations and tries to short expensive stocks, cannot be blithely indifferent to the path a security takes in finding its correct price. Under existing market institutions, ordinary short investors have to maintain a collateral for stock they have borrowed and sold that varies with the path of the security price. If a stock "worth" 1 dollar is absurdly valued at $5, there is no reason to think it might not transiently reach the absurd value of $10. As David Merkel notes, "twice absurd is still absurd." But while a buy-and-hold investor on the long side can just hold an absurdly undervalued stock, a buy and hold investor on the short side has to "cover" the increased debt implicit in her short position by putting up hard cash. Any short investor can be put out of business by a sufficiently large spike in the price, however transient, low-volume, or downright absurd.

There are lots of differences in costs and risks between "selling short" and "buying long". There are even some asymmetries — only applicable to very large, very creditworthy, investors — that work in favor of shorts. But for the vast majority of buy-and-hold value investors, the possibility of being 100% correct on the fundamentals but wiped out by a spike makes shorting simply not worth the risk. It's value investors who force stocks to reasonable prices. So called "technical" investors and traders don't care, they'll follow momentum from one greater fool to the next without batting an eyelash. The only value investors who do have the capacity to sell, investors with an previously-purchased inventory, are an unrepresentative sample of the value investment community (bullish enough earlier on to buy), sticky (buy and hold investors usually hold), and subject to behavioral-finance effects like finding it hard to sell a position that's earning money. Under these circumstances, there is a systematic bias for prices to generally rise, but to fall suddenly when some news or trend calls attention to the mispricing way so vividly that it juices the traders and gets the portfolio investors nervous about holding.

In other words, with the short-side so under-represented among value investors, it shouldn't be surprising that bubbles tend to gently grow, then suddenly pop. And so they do. And the costs are enormous.

This is not rocket science or genius. This is obvious stuff. Again, that it hasn't been fixed, that this institutional bias in favor of one kind of opinion has never been controlled, is a blot and a shame on the financial community.

p.s. For some kinds of investments, the bias against shorting is very strong. It is very hard, for example, to short housing. Maybe new derivative instruments will partially change that, but the risk characteristics of futures and options make them also unpalatable to the value investor, and the arbitrage strategies that usually link derivative securities to fundamental investments won't work well with housing. Bubbles have lots of apologists, and it is easy to confuse the present institutional forms of markets for "nature", so the idea that markets as presently consituted are badly broken and should be intentionally reformed to track value with price more precisely comes off to many as utopian science-fiction. My opinion is that when the US housing and liquidity bubbles burst, this kind of talk will seem very moderate.

Just after graduating college more than a decade ago, I heard Michael Albert explain that some of the mayhem associated with demonstrations against the Vietnam War were part of an intentional strategy to "raise the cost of the war at home". In very dry terms, the idea was that feedback mechanisms were out of whack, that those bearing the costs of the war were far away and Asian, while those fundamentally perpetrating the war lived in American cities, and that in order for rational policy to prevail, Americans had to experience some of its costs. Since there wa no "natural" mechanism whereby costs to Asian villagers might be shared by Boston suburbanites, activists stepped into the breach and manufactured costs. There was something compelling to this reasoning, I couldn't reject it out of hand. And yet, there was something obviously dangerous, and dark about it. There ought to be better ways to encourage rational policy choices than by breaking shop windows. And as a very intuitive and wise college friend said about this line of reasoning, she was skeptical of any kind of politics that required the destruction of good things in order to do good things. Over the years, I've been more and more impressed by my friend's simple intuition and less persuaded Albert's impeccably reasoned argument.

As a short, I stand to profit from destruction of value, whether "creative destruction" or otherwise. I could claim that my investments are only a matter of sober prediction, and do not represent hope or advocacy. But, psychologically, it is very hard to resist "thinking ones book". Over the last year, I have come to believe that the US economy really ought to fail, badly, hard, and fast, that it would be better in the long term for both the US and the world if what I see as a pattern of unbalanced, debt-driven, currency-and-market destabilizing growth would end sooner rather than later, so that the eventual costs of setting things right are minimized and taken is as short a time-period as possible.

I claim to be optimist, especially about the US. I'm a great chauvinist about what I take to be the central ideas underlying the United States' politics, economics, and culture. I think that many of these ideas are fundamentally right, are universal and ought to be universally applied. I think the United States is the best thing ever, not as a particular nation-state, but as an exemplar of a framework for human affairs. But nevertheless, I think the US as a nation-state has erred perilously, that world capital markets have failed in their role of providing ongoing feedback to promote wise behavior, and that the US should take some serious lumps that it may find its way back to the path of righteousness. I do think that the US would do fine, in fact would do much better than fine, if its economy were set on a reasonable basis, after an "adjustment" as the economists like to say, after the revolution in the coinage of an older school. I want things to get worse in the US so that they can get better.

It's the Bolshevik old saw, "the worse, the better," not a point of view I'm flattered to associate myself with. It's like Michael Albert's argument all over again, which I thought I had discredited to myself. It's a set of ideas and beliefs that were nearly inchoate when I took my investment positions, that have evolved and crystallized in the context of my being a short. I feel like I have to treat these beliefs with some skepticism. So should you, dear reader. And yet, however I have arrived at them, they are my beliefs.

The central bank of a country that issues debt is the ideal agent for debt sequestration: It never requires cash flow, and its primary goal is to prevent disruption of the economy it helps to regulate. This form of sequestration is called "monetization of debt", and is indefinitely stable. The only downside is that purchases of debt by a central bank may lead to inflation. To the degree central bank debt purchases can be managed without inflation (perhaps due to disinflationary forces elsewhere in the economy), the debt-issuer's central bank is the ideal sequesterer of debt.

Foreign central banks can also serve to sequester debt, but they are "leaky". There are two risks associated with foreign central bank sequestration: 1) Sequestration by a foreign central bank may not be permanent — the debt-issuing economy bears the risk of a disruptive change of policy by a foreign central bank; 2) Foreign central banks may expect cash-flow in the form of interest payments on foreign debt, even if they are willing to permanently roll-over principal. (Cash-flow to domestic central banks is usually an accounting fiction, since a central bank's profits are remitted to the debt-issuer.)

Any level of debt-to-GDP is sustainable with sufficient sequestration. Any amount or rate of debt expansion is sustainable so long as there are actors willing to continue to sequester more debt. However, the greater the stock of sequestered debt, and the greater the rate of debt expansion, the greater the risks of a change in policy, especially by a foreign central bank.

These are the risks Roubini and Setser have long highlighted with respect to the United States' deficits. However, the willingness and capacity of Asian and petrostate central banks to sequester US debt have flown in the face of most people's intuitive limits of plausibility.

At this point, it's not enough to say "wow, that's a lot of debt". Debt-to-GDP can approach infinity, notwithstanding whatever the level was in 1929. If you want to say that things will change due to supply-side constraints, you've got to explain why the capacity of debt-sequesterers will be exhausted, or why their policies are likely to change.

(crossposted from here.)

Sometimes it is worth remembering that what is taken as very ordinary is in fact very odd. Positive real interest rates are one of those things.

In a simple telling, an interest rate is how much one has to be paid to defer consuming goods and services available now until sometime in the future. When one frames the question this way, it seems natural that this should be a positive value: why should I wait to eat my ice cream, when it's the same ice cream now or tomorrow? Deferred gratification seems less fun than instant gratification, so you should have to pay me if you want me to hold off. Right?

But even in this simple tale, it is obviously not necessarily right. If you have a whole tub of ice cream, and it's just you, the "decreasing marginal utility" of gluttony now kicks in pretty quickly. After about the third scoop, it's not so fun, and the utility of consumption by dumping in the garbage can is quite low. So in fact, most of us are willing to purchase, maintain, and fuel an expensive device to permit us to defer consumption to a utility-maximizing future moment: the refrigerator.

The fact that it is costly to store stuff, and that lots of stuff is perishable and does not store well, is a prima facie argument for negative real interest rates! At some level, it ought to cost you something to control the timing of your consumption, especially in an imperfect world with limited space and where things are constantly breaking.

In the real world, economies don't work like this, precisely because savings does not map to the storage of stuff. Economies are amazing, dynamic beasts in which stuff that will not be consumed today is not much produced today, avoiding these costs and inefficiencies and gluts of things no one wants. "Saving" is about channeling our energies into preparing to produce tomorrow rather than storing what we have today. It is because we usually get better and better at producing stuff, if we prepare for the future rather than producing and consuming all we possibly could today, that interest rates are positive. Even if I prefer to eat ice cream tomorrow rather than today, tomorrow we'll be better at making ice cream, especially if I'm willing to lend a hand to building a better frozen-cow milker instead of gulping down those ten scoops now. In exchange for my deferral in consumption, regardless of whether waiting was subjectively costly, I'm should be entitled to a share of tomorrow's great bounty.

So note that the true reason interest rates are positive isn't that you have to pay someone to defer consumption. It's because deferring consumption helps to promote more future production, and in a fair system, the deferrers should get a piece of that.

Not all futures are more bountiful than today. It's possible, due to poor investment (deferring consumption to do things that turn out not to be helpful, or even harmful, to future production) or economic "cycles", for things to be worse tomorrow than today. This is the situation in which economists expect people to realize negative real interest rates.

But even in a growing economy, where the future is in fact more bountiful, people may willingly save and realize negative interest rates! Why? Because not all systems are fair (none are perfectly fair), and the rewards for deferring consumption may not be awarded to the saver. Does this mean that people won't save in these economies? Of course not. In fact, it may very well mean that people will save much more than in economies where people expect to earn high positive interest rates.

As we saw in the parable of the ice cream, controlling the timing of consumption is itself a good, a good for which people would generally willing to pay. If there is no way safe way to realize a return on savings, people nervous about the future will accept costs and save anyway. If the cost of saving — the negative real interest rate — is likely to be high, people nervous about the future will save even more, to offset those costs. Insecurity can promote savings at least as well as optimism. Perhaps the way to increase savings is not by presenting savers with an expectation of stable high returns, but with the likelihood of low, even negative real returns (although always positive nominal returns). The latter approach has the advantage of encouraging savings while permitting bankers, governments, and others to profit on the spread between high positive economic returns on investment and negative real interest rates paid to savers.

Do you think this might have something to do with China? And with who is really paying for those imported goods that seem so cheap in terms of US dollars?

What is odd about all this is not that it implies a policy of theft and expropriation by the state on a massive scale. History is full of massive state theft and expropriation. What is odd is that in China's case, it seems to be genuinely good policy, not just for bankers, and politicians, and nouveau riche exporters, but for the state as a whole. It's pretty clear that China's development has outpaced that of any country that's ever tried the neoliberal Washington consensus.

Claims that China is still a communist country are often dismissed as nothing more than a historical conceit of capitalism's new Wild East. But maybe China really does represent a new and interesting take on communism. Using the old words, one might describe China as allowing the development of a small bourgeoisie, with its constant revolutions in production, while harnessing the arcane machinery of bourgeois financial institutions to nationalize much of the wealth produced by the proletariat. Expropriation via high finance is superior to taxation or outright nationalization, because it masks itself as a fact of nature, as something implicit to markets and currencies and banks. It also has the advantage of turning the bourgeoisie into an ally rather than an adversary of the confiscatory state. Since the bourgeoisie are financially sophisticated, they can avoid expropriation of returns by working outside the state-regulated money and banking system. Plus, the state uses part of the excess returns extracted from the proletariat to buy the support of the bourgeoisie, while the rest can be used to pursue national goals. At the moment, China's currency policy captures much of the action: By subsidizing exports, it buys off the capitalists; by preventing Renminbi appreciation or deflation, it robs real returns from ordinary savers; and by encouraging development and increasing China's economic and industrial power, it serves state interests and arguably the public good.

Read a bit further and you'll find that rather than being a story about incipient hyperinflation in China, the real story here is just how hard it is to raise prices in the new wild East of capitalism. To manage a 15% price increase in the price of noodles required a campaign of organized intimidation on the part of noodle-sellers unhappy with their margins.

"They came over and handed this to me," said Mr. Ma, showing a two-page agreement that called for every shop owner to raise prices. "They said, 'If you don't raise your prices, we're going to tear down your shop sign.'"

And still, given China's hypercompetitive environment and increasing supply of noodle-sellers, the price increase seems unlikely to stick.

[Noodle-seller Zhang Wei] got a visit from the noodle cartel, and his wife even signed an oath with a thumbprint, pledging to raise prices. But after Mr. Zhang saw the newspaper coverage, he returned his prices to the lower rate. "I had a lot fewer customers after I raised the prices," he said.

The market for noodles in Lanzhou is hardly the city of London in moving the global economy. But for economists amazed that China's booming money supply seems to exact none of the traditional costs of an overhappy printing press, the Yellow River noodle-sellers tell the tale.

And for all those Western workers and businesses trembling in the face of Chinese competition, here's a healthy reminder that the only thing worse than being a foreigner and having to compete with the Chinese is being Chinese and having to compete with the Chinese.

In the comments to this post, HZ asked of Dr. Setser...

Brad,
Since total money is equal to consumer borrowing + government borrowing + corporate borrowing + foreign borrowing, I have two questions:

A. Do you see total money supply too high?

B. If not, and since we want consumer borrowing and government borrowing to go down, to avoid deflation which one do you want to see step up borrowing? Foreigners?

DF responded with...

In fact I don't agree with "total money is equal to consumer borrowing + government borrowing + corporate borrowing + foreign borrowing" Bills and coins are not related to any kind of borrowing.

...which kind of set me off. Here's my response, what I think about the relationship between debt and money, without getting into rather poor formalisms like M1, M2 and M3.

DF — Money is always debt. At a very fundamental level, that is what money means. To hold money, whether as numbers in a bank or bills in hand, means that somebody, somewhere owes you something. The genius of money is that rather than anyone in particular owing you something when you hold your 10 euro bill, you can think of it as simply being "owed" 10 euros worth of goods and services. But there is a counterparty even in holding the 10 euro bill. The ECB is in your debt, but it is in your debt under terms that are very unfavorable to you. You cannot force redemption for any normal good or service, and they won't pay any kind of interest. But they will guarantee the service of offsetting 10 euros worth of taxation by any euro member government in exchange for surrendering that bill. Fundamentally, fiat currency represents debt by a government or governments to offset some confiscation or compulsion they might otherwise subject you to. Even those not subject to taxation find state tender valuable, for the goods and services they can acquire from citizens who do require an offset to taxation. States proclaim this form of very advantageous (to them) debt to be the legal medium of exchange, and have for the moment succeeded quite well at making it so. I sound like some nutcase gold bug putting things into these terms — for the record I don't believe in a gold standard or anything similar — but in conceptual terms, and on the balance sheets of central banks and governments, those coins in your pocket are in fact debt.

HZ — All money may be debt, but not all debt is money. The line is blurry, but to be money in a money supply sense, debt has to have some likelihood of being used as a medium of exchange. A bank's debt to you in a checking account is close to money, because you ordinarily might make exchanges by giving that claim on your bank to someone else (with a debit card, or via the quick intermediation of ATMs or credit cards). But the bonds held by PBoC are very far from money. If PBoC were simply to "burn the certificates" on 100 billion USD of the Treasury's debt to it, there would be no meaningful effect on the supply of money that actually participates in exchange, so it would not be deflationary. Wanting debt to disappear is not necessarily the same as wanting money to disappear. If PBoC would simply forgive the US debt represented by its reserves, that would be a straightforward positive for the US economy. Heck, it'd be downright inflationary, as Americans would take it as license to take on more debt, of a more money-supply participating sort.

All that money PBoC is holding is potentially inflationary, if China were to go on a spending spree. But that is just another way of saying that the value of the dollar would tank if PBoC decided to divest itself of dollars, which everyone who's ever read Brad's stuff knows very, very well.