In Theory…

Two recent articles really highlighted the degree to which economists continue to treat the economy and markets as if they were true sciences as opposed to social sciences. The recent nobel laureate Eugene Fama was recently asked about the existence of bubbles to which he replied “I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.” The other article which also illustrated this ivory tower view of reality was the NY Times front page article on inflation. This article discusses the real dangers that lie in deflation, and goes to great lengths to articulate the positive aspects of inflation: pricing power, wage inflation, etc..  However, what both fail to deal with are the behavioral nature of the economy and markets. Professor Fama and Rogoff fail to adequately account for the fact that peoples behaviors are not driven necessarily by a rational examination of the facts, but rather by their expectations of their facts as they interpret them. The credit and housing bubbles were driven by behavior  that was motivated by a set of facts that became self reinforcing (the pricing of both credit and housing would always remain advantageous). When the pricing of credit and housing became discontiguous and fractured, rationality was the ultimate victim. This type of self reinforcing behavior also becomes readily apparent in periods of rising inflation. Inflation, while it may be initially set in motion by external factors such as a drought or oil shock,  ultimately becomes a lesson in behavioral expectations as price rises become ingrained across the board. While it is true that this is temporarily a positive for producer pricing, the end result is a decline in overall purchasing power, a decline in the value of ones currency,  and a gross misallocation of resources. We continue to feel that Central Banks around the world put much credence in their own ability to micro-manage certain outcomes, many of which are not driven by fundamentals but rather by participant expectations. While we do not profess to know the future, we still strongly believe that the omniscient attitude that pervades the conference rooms of all global Central Banks will set the stage for the next secular shift towards hard assets.

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