11/12/2009: For a true goldbug, gold is not expensive yet

According to Warren Buffet, “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.” Gold’s main role is as a store value, so it needs to be scarce. And it is: all the gold produced throughout history could fit into a cube 25 meters a side, which is roughly a third the volume of the Arc de Triomphe or the Washington Monument.

Demand ultimately sets the price for gold and market sentiment is the principal driver—the darker the economic mood, the higher gold price. And once in a while, gold can embark on a sentimental journey that truly has a life of its own, untethered from fundamentals and common sense. Yes, even one of nature’s heaviest substances can form a bubble.

The last time a real gold bubble inflated was in January 1980, when it hit 850 US dollars per ounce and delivered a 100% annual return for 1978 and 1979. Despite setting a new all-time record recently at 1,064 US dollars an ounce, gold is still far away from matching that thirty-year-old bubble. Considering the purchasing power of 850 US dollars in January 1980, an ounce of gold would have to sell for roughly 2,360 US dollars to equal 1980’s punch, another 120% from its current levels.

While this comparison is certainly a useful one, we can even dig deeper by looking at an equilibrium value for gold. A word of caution first: unfortunately, unlike dividend discount models for equities, or purchasing power parity models for currencies, there is no universally accepted equilibrium model for gold.

But several economists have come up with an intriguing approach to modeling gold’s value: consider, they propose, the price gold would carry if US gold reserves were to cover completely America’s monetary base, i.e. all the dollars in public circulation and in commercial banks’ deposits with the Fed. The US possesses some 261.5 million ounces of gold and its monetary base is about 1.78 trillion US dollars. To back this base completely, the price of gold would have to reach 6,790 US dollar per ounce. Interestingly, at the time of the last bubble, at 850 US dollar an ounce in 1980, gold actually covered the US monetary base one–and-a-half times! To reach that dimension of coverage today, gold would have to ascend to a whopping 10,185 US dollar an ounce.

There is one caveat to this approach, of course: it is simply too US-centric. In the late 1970s, even in the aftermath of the Bretton Woods breakup, the old model still applied: every currency was backed by the US dollar and the dollar backed by gold. Today, the US monetary base is dwarfed by the size of foreign exchange reserves worldwide, so it might make more sense to take a global view in assessing gold’s fair value.

But first fasten you seatbelts because if global FX reserves were to be backed by gold, gold’s price would have to reach 8,830 US dollars an ounce. Shifting up a gear, in January 1980, at the peak of the gold bubble, global gold reserves covered the global exchange reserves two and a half times. Duplicating this today would lead to a gold price at a staggering 22,075 US dollars an ounce!

Needless to say, these numbers are neither forecasts nor price targets. However, we think they do put the current gold price in a useful context. If we are in a gold bubble, then we are still in an early stage.

10/12/2009: Crisis' tipping point

Pop sociologist and bestselling author Malcolm Gladwell coined the phrase "tipping point," referring to that instant when momentum for change becomes unstoppable. With the publication of the surprisingly positive US labor market report for November, on 4 December, we just might have reached such a moment.

A first interpretation might consider the report a business-cycle tipping point. The cheering labor data at least hints at a definitive end to the US recession, although cautious economists would need to see confirmation of such a judgment in December’s data.

However, the real tipping point wasn’t the labor market report at all, but the market’s reaction to it. One of the most striking features of the financial crisis was the high correlation among all kinds of assets. With the exception of government bonds and cash, supposedly unrelated performers behaved like synchronized swimmers as they headed for the bottom in 2008. In 2009 this high correlation continued, especially after March, as every investment, including even government bonds, delivered decent to outstanding returns.

This unusual collective behavior did not reflect portfolio shifts. Rather, it was surely due to the immense amount of liquidity that central banks worldwide injected into the economy to counter the credit crunch. This money flowed into almost every asset class, lifting the prices for bonds, commodities and equities. The only real loser this year has been the US dollar, which, given the negligible US interest rates, has taken over from the Japanese yen as the darling funding currency for carry trades.

But after US labor market report, we think the market is finally differentiating again, for the first time since March: equities increased in sync with a strengthening US dollar, while both bonds and gold lost some ground. This is, historically, a normal market reaction when participants start to believe in a recovery.

While it is too early for an all-clear signal, both the US labor statistics for November and the market’s reaction can be seen as the first signs since the crisis hit that the economy is truly mending. This would obviously be a solid basis for 2010.

03/12/2009: Skyscrapers' omen

There’s an old adage that only a fool builds a house upon sand. We could modernize this by saying it’s foolish to build a skyscraper upon a bubble of credit. Indeed, looking at the history of financial crises over the past hundred and fifty years, building heights offer a rather good indicator of economic excess.

Let’s look at the record. The first skyscraper to rise above 100 meters, the now demolished Manhattan Life Insurance Building in New York, was built in the middle of the 1890s depression. The first to surpass 200 meters, the Met Life Building in New York, was completed just a year after the banking panic of 1907. The Chrysler and the Empire State Buildings (respectively 282 and 381 meters) were completed in the early 1930s. The World Trade Center (417 meters) was built in 1972 and the Sears Tower in Chicago (442 meters) in 1974, in the middle of the first oil shock. The Petronas Towers in Kuala Lumpur (451 meters) was completed in 1998, a year after the Asian financial crisis. There’s plenty of evidence for what economists would call a positive correlation between tall buildings and bubbles.

Thus, Dubai’s recent race to skies should have warned us of a possible crisis. The Burj Dubai, topped out in January 2009, soars to 818 meters (2684 feet), by far the tallest structure ever built. But even this giant would have been dwarfed by another planned super-tall building in Dubai, over a kilometer in height, the Nakheel Tower. This dream has been put on hold for the time being.

After triggering an initial wave of panic throughout financial markets worldwide last week, things have returned to normal and equity markets continue to rally. So we can say that the liquidity-induced market pickup this year may have withstood its first real test. But the Dubai incident also shows how frayed the nerves of market participants still are.

While the default of the government-backed investment company Dubai World does not equate to a default by the government of Dubai, it does serve as a chilling reminder that debt has its limits. Even with no tall building as an emblem, we must acknowledge that the skyrocketing amounts government debt worldwide are also built upon the sands of credit and are simply not sustainable over the long haul.

And if we take the skyscraper indicator seriously, there is good reason to remain rather cautious and alert. According to skyscraperpage.com, sixteen buildings over 400 meters in height are currently under construction worldwide, fifteen of them in emerging markets and almost half of those in China alone.

27/11/2009: The euro's strength is its weakness

Spare a thought for the late Willem Duisenberg, first President of the European Central Bank. He was mocked during his tenure not only for his spectacular hair but also for his numerous gaffes, which, given the skepticism that greeted the single European currency at its launch in 1999, did little to inspire confidence.

He surely would be proud now, because the euro is stronger than ever. Starting at around 1.18 against the dollar in 1990, the euro slid near to 0.80. But today, at over 1.50, it is roughly 20% overvalued against the greenback.

Yes, after initial doubts, the euro is a success. But let’s be honest: it is much more the child of the mighty German mark than of the jittery Italian lira. It has proven itself an anchor of stability during the financial crisis, even keeping a euro-in country, Ireland, from the bankruptcy and depression that was the fate of a euro-out country, namely Iceland. And in the aftermath of the crisis, many battered Eastern European countries seem to recognize that giving up their sovereign minted currencies is not such a bad idea. Or is it?

One doubt often expressed about the euro centers on the heterogeneous mix of countries using it. At the one extreme stands rock-solid Germany, still exporting successfully and offering real competition to the workshops of Asia on the world market. At the other end teeters profligate Greece, whose government debt, already exceeding 100% of GDP this year, is heading for very thin air at over 130% during the next two years, according to European Union estimates. Can it really make sense that such opposites coexist in one currency union?

Actually, yes. Even though Germany might consider the southern European countries a drag on overall European finances, and even though the exports of laggards like Greece are seriously impaired by the euro’s strength, we think both countries will stick to the euro.

Consider: if the Germans would opt out, their new currency would skyrocket against the euro (estimates range between 20 and 30%). This would price German exports out of the markets they have fought so hard to win, ultimately leading to an economic depression. And if Greece were to abandon the euro, its new currency would depreciate drastically versus the euro, briskly driving Greece to default on its debt, which, after all, would still be in very expensive euro.

So despite its heterogeneity, the Eurozone is what Germans would call a Schicksalsgemeinschaft, a community joined by a common fate. Hence, the risk of the Eurozone falling apart, as some investors especially from beyond its borders believe, is relatively low. However, there is a caveat: If a country like Greece were actually to default, opting-out could then become a very appealing choice, since it could reset the country’s finances.

This leads to two conclusions. First, regarding their public finances, all Eurozone governments have moral hazard. They know that the threat of exiting the euro would spur other member states to help them if they were near to default. Second, although it is probably the most independent central bank in the world, the ECB does have its limits. If its strong-euro policy threatened to bring on deflationary tendencies that moved one or more member states to default, this could well put the euro at risk. So the common currency has something in common with mythological creatures: its great strength also contains the seeds of its potential destruction.

26/11/2009: The inconvenient truth about Chinese-American trade

"Today millions of Americans are out of work because the Chinese are manipulating their currency." US Senator Charles Schumer’s blunt statement has an obvious, seductive logic. If China would let it float freely, its currency would surely appreciate sharply versus the dollar, driving down the prices of US exports to China and elsewhere. US firms would thrive and jobs would be plentiful.

What a happy ending! And hence the growing chorus in the US calling for trade sanctions on Chinese products if Beijing refuses to stop controlling the value of its currency.

But we have been down this road before and what an ugly trip it was. Raising import tariffs on over 20,000 items, the Smoot-Hawley Tariff Act of 1930 also aimed at protecting US jobs. Today, historians and economists agree that Smoot-Hawley merely amplified the Great Depression’s misery, since America’s trading partners retaliated with tariffs of their own, to everyone’s detriment.

The prospects for protectionism are even worse today. Just imagine that the Chinese authorities would agree to let their currency free-float. Yes, China’s exports to the US would grow more expensive for Americans while America’s exports to China would be cheaper. So far, so good.

Now comes the really nasty bit: the US would probably still import much the same amount of goods from China as now, but would simply have to pay a higher price. Why? Because most Chinese exports to the US are simply no longer produced in America. And, just to be clear, the Chinese didn’t "steal" US jobs. Those jobs were already long gone before the Chinese export wave landed on US shores. In this regard, China competes more with Mexico and other emerging markets than with America.

So no big job relief from updating Smoot-Hawley. But the picture grows even uglier if we contemplate what a free-float would mean for US Treasuries. Suddenly, as their relative value plummeted, one of their biggest buyers, China, would probably simply stop buying these securities. They might even opt to sell some of their two trillion US dollar reserves. Given the swelling ocean of US debt issuance thanks to growing government deficits, reduced demand for Treasuries from a primary buyer would put enormous pressure on the price of these bonds while sending interest rates skyward. Not at all a formula for a jobs recovery!

With the US economy still shaky, it could definitely not afford such a development. Echoing Senator Schumer, but with a crucial twist, we would have to say, "Tomorrow millions more Americans might be out of work if the Chinese were to stop manipulating their currency."

19/11/2009: What is money worth, if anything?

Andy Warhol’s silkscreen “200 One Dollar Bills” just sold for 43.8 million US dollars at Sotheby’s in New York. This is good news because the fact alone that people are buying again art in a big way, shows that yes, the financial crisis might be over. But it leaves also a bittersweet feeling with regards to the vanishing value of money. Accounting for the actual inflation, 200 US dollar in 1962, had the purchasing power of 1,400 US dollars of today. The US inflation multiplied prices by seven in the last forty-seven years, an average yearly inflation rate of 4.2%.

To reach 43.8 million dollars with 200 dollars of 1962, of course real one and not the ones painted by the founder of pop art, one would have needed an average yearly inflation of 29.9%. This number might seem excessive at first but it wouldn’t even qualify to be considered as “hyperinflation”. Between 1983 and 1992 Argentina, experienced a yearly inflation of 70%.

Prices for art are going up again but so do prices for every other major assets. A client asked me a couple of days ago, whether emerging market equities could be considered as the next asset bubble. Why not? But looking at the returns since March 2009 one could currently equally make this case for commodities, government bonds, global equities, or gold. Everything is just going up. The high correlation of asset prices spotted during the financial crisis and the crash last year hasn’t vanished at all.

One can find a fitting story for each asset class. Equities are up because, we ultimately didn’t experienced the end of the world as we know it. Moreover company profits have surprised and are continuing to surprise positively, and so does the economy. Government bonds are up, because actually we aren’t out of the woods when it comes to assess the credit crunch. There is still the risk of sliding in a Japanese-like lost decade, during which, Japanese Government Bonds were the only Japanese asset actually performing. Gold is up, because confronted with the huge liquidity creation of central banks and the abysmal debt creation of governments, inflation might become a serious issue going forward.

Given the multiple and contradictory stories around, paradoxically despite the extraordinarily high correlation of asset prices the best strategy remains to be broadly diversified and not necessarily only focus on one possible view of the world. What all the current stories have in common is the fact that the value of money, expressed in asset prices is shrinking. If this were to continue the next asset bubble would be plain and simple: assets.

13/11/2009: The Fed's trouble with bubbles

Not only have we suffered a grave financial crisis over the past year-and-a-half; we also have a crisis in economic theory, particularly regarding the role of central banks. Back in the simpler world of 2007, the mission statement for central banks consisted of “inflation-targeting.” Their principle tool was interest rate policy.

Ben Bernanke, the current Fed president and former Princeton economics professor, has been a very strong advocate of inflation-targeting. He edited a tome on the subject in 2001 with Columbia’s Frederic Mishkin, who was a Fed governor from 2006, when Bernanke became president, until in 2008.

But there were a few dissenting voices before the financial crisis. They came mainly from the so-called Austrian School, named in honor of economists Ludwig von Mises and Friederich Hayek. They argued that by focusing only on inflation, defined as an increase in consumer prices, central banks risked conducting overly expansive monetary policies that could easily lead to asset price bubbles. The tech and housing bubbles of the past decade did not lower the Austrian School’s credibility, it must be said.

Before the housing bubble burst, central bankers, especially those of the Fed, countered the Austrians’ critique by saying that bubbles cannot be recognized until they burst. In the words of former Fed President Alan Greenspan, “If markets can’t recognize bubbles, neither can regulators.” But were they even looking, or did they simply ignore bubbles?

Reviewing Iceland’s economy in 2006, Mishkin wrote, “The analysis in our study suggests that although Iceland’s economy does have some imbalances that will eventually be reversed, financial fragility is currently not a problem, and the likelihood of a financial meltdown is low.” Was this analysis, in the clinical, scientific sense of the word, or was it wishful thinking? Iceland made news shortly after Mishkin’s rosy prognosis, as its banking system essentially failed.

Obviously, recent financial traumas have led central bankers to review their inflation-targeting paradigm. They now acknowledge that if the US housing bubble had been on the Fed’s radar, the catastrophes of 2008 might have been avoided. This is good to hear, but we think the Fed still has some troubles with bubbles.

In an op-ed piece in the Financial Times on 10 November entitled, “Not all bubbles present a risk to the economy,” Mishkin offered a glimpse into the Fed’s mindset perhaps. He distinguishes between two sorts of bubbles, the dangerous “credit boom” types and the benign “irrational exuberance” bubbles. The former can threaten the entire banking system so they demand action by central banks. But the latter should be free to swell until they burst, in Mishkin’s view, because they “do not present the same dangers to the economy as credit boom bubbles.” Finally, he argues, bubbles of exuberance should be tolerated because bursting them early, through policy actions or publicity, would lead “to much weaker economic growth than is warranted.”

Hence, grappling with the housing bubble would have been wise, but the tech bubble should not have been impeded. Mishkin thinks the tech bubble’s harmless nature explains why, when it burst, it “was only followed by a relatively mild recession.” Right.

We think this is a rather bold, even fantastical, interpretation of recent economic history. The US recession in 2000-2001 could, and probably should, have been much worse. The Fed only contained its consequences by inflating the mother of all credit bubbles, whose puncture plagues us today.

Mishkin’s dual (or double-bubble) approach leads him to conclude that “tightening monetary policy in the US or Europe to restrain a possible bubble makes no sense at the current juncture.” I once read that history was “written by the winners.” We can only hope that policymakers and central bankers now see that controlling bubbles of all sorts is indeed an important mandate.

05/11/2009: Professor Laffer goes to Germany

In 1974, on what was to become one of the most famous napkins in economic history, a young professor from Chicago, Arthur Laffer, sketched a statistical curve for Dick Cheney, then Deputy White House Chief of Staff, hoping to convince President Gerald Ford not to increase income taxes by another 5%.

The Laffer Curve, as it is now known, argues that raising taxes does not necessarily increase tax revenues. There is a tipping point in tax rates beyond which tax revenues actually diminish. Setting taxes too high creates a disincentive to earning, since the government simply takes a bigger bite of the income. Laffer’s idea was hardly new; no less than John Maynard Keynes once expressed a similar view. Indeed, the concept dates back at least to the great 14th century Arab scholar Ibn Khaldun.

While President Ford didn’t embrace the Laffer curve, it found more sympathy with advocates of what came to be known as supply-side economics or Reaganomics, after the fortieth US president. It never really went away but it was revived with gusto by the forty-third president, George W. Bush. US supply-siders argued that cutting taxes would increase tax revenues as all that untaxed income “trickled down” through the economy, raising incomes and, thus, tax revenues. But this never really happened. While the overall US economy grew robustly in the late 1980s – and some of that growth can fairly be attributed to tax cuts – it was not revenues but rather the government’s deficits that increased, and to dizzying heights.

There are several reasons why lower taxes failed to boost tax revenues. For one, the marginal tax rate in the US was already below the tipping-point tax rate. Hence, lowering it only led to lower revenues. A more subtle reason was given by another young conservative Chicago economist, Robert Barro. In an important paper, also published in 1974, he argued that people don’t see much difference between taxation and government debt because they know intuitively that today’s deficits are tomorrow’s higher taxes. When tax cuts only increase the government’s deficit, households and companies will not change their behavior. So if you want tax cuts to really have an impact, you also have to cut government expenditures.

Most economists today dismiss the Laffer Curve, and Reaganomics, given the poor results of both. Nevertheless, these ideas still resonate with many politicians. Lately, the German government has sought to justify its bold, new tax cuts along those lines. While we wish them every possible success, we are deeply skeptical. It remains to be seen whether Germany’s marginal tax rate exceeds the tipping point. Moreover, given Germany’s popular distaste for big government deficits, Barro’s argument is even more likely to apply there than in the US.

30/10/2009: A golden paradox in the making

“As good as gold,” we say to indicate certainty and worth. Gold is safe, according to common wisdom, so rising gold prices are a sign of rising worries. Stock markets, too, are barometers of sentiment, rising or falling with the outlook for the economy.

But lately both shares and the gold price have been on a roll. Gold recently set a new record against the US dollar at around USD 1,050 an ounce. And the Dow just broke the symbolic 10,000 mark, a move that many commentators see as a sign that the financial crisis is over.

Something is wrong with this picture. How can both gold and equities rally at the same time? Is the market schizophrenic, with investors hedging their stock positions by purchasing gold? Or is this yet another skirmish between stock market bulls and gold bears?

Actually, we see a better explanation for this double surge. To connect the dots of causality and correlation, we see one factor common to both rallies: the deeply sagging US dollar. Why is the dollar behind both surges? In short, because carry trades are back.

Carry trading is an investment strategy that calls for borrowing in a low-yielding currency to buy assets in a high-yielding currency. Carry-traders get a quick win from the yield differences, since the higher yield of the purchased assets exceeds the cost of the debt in the low-yielder. When carry trades are in fashion, the exchange rate between the two currencies generates a second gain: High-yielding currencies, being in demand, appreciate against the abundant low-yielders.

The favorite carry trade of the past decade used the Japanese yen for funding and the Australian dollar for investments. Between 2003 and 2007, this trade enjoyed an average annual interest rate differential of 5% and the Aussie appreciated 10% per year versus the yen. Easy money, while it worked. Then, in the course of 2008, the Australian dollar lost 45% against the yen, more than erasing all the gains of the three previous years and putting an end to the strategy of carry-trading, or so it seemed.

But a funny thing happened in 2009: carry trades returned to fashion. The Aussie resumed its starring role as investment currency and the yen reprised its ugly duckling turn as funding currency. But this time the yen has a rival: the once-mighty US dollar. Currently, money-market interest rates paid on the US dollar and the yen are about the same. So the new carry-trade mantra is: borrow cheap greenbacks; buy Aussie assets.

Let’s be very clear on this: it is not the recent dizzying increase in US government debt that explains the dollar’s current weakness, nor is it the astonishing output of the Fed’s printing presses. Carry trades are the cancer eating at the US dollar’s value today.

Now we can connect the dots between the equity and gold rallies: it is precisely the greenback’s weakness that is driving up the price of gold. For a euro or a Swiss franc investor, gold has barely moved this year; for a dollar investor, gold has performed rather well.

We see the makings of an exquisite, truly golden, paradox in the surges of equities and gold: If, for whatever reason, stock markets were to fall by 10%, we might not see gold appreciate in US dollar terms, as would normally be expected; but rather gold’s price would tumble as the unwinding of carry trades would strengthen the greenback.

The financial crisis may be over but one of its notable aftereffects, the high correlation of usually uncorrelated assets like gold and equities, definitively is not. And we expect to see more such paradoxes in the near future.

29/10/2009: Pick your poison: deflation, imbalances or inflation

With its public deficits climbing dizzyingly into the trillions of dollars and a government debt-to-GDP ratio ominously approaching the 100% level, the US is in a fiscal tailspin. But despite all the red ink, its debt is still finding buyers, allowing US interest rates to remain very low, at least for now.

Who is buying America’s debt? This is a vitally important question because where the US is headed, the world will follow, and much will depend on who proves to be the “buyer of last resort.” There are only four possibilities here: US households, foreigners, the Fed, and financial intermediaries. Let’s look at the implications for each.

If US households buy their government’s debt, they are, in effect, saving more. While this is virtuous behavior and would help to ease global imbalances, it would also stifle consumption, which would cripple the US business cycle and, by extension, global growth. In fact, if only US households were buying US government debt, America would slip into a Japanese-style deflationary spiral, as subdued domestic private demand hobbled growth and fueled an explosive debt-to-GDP ratio, which in Japan is now set to pass the mindboggling 200% level.

If foreigners buy US government debt, they merely reinforce the abysmal imbalances between the US and the rest of the world. Indeed, they would hinder a much-needed dollar depreciation as they stockpile more US dollar reserves. How high is up? China’s reserves just passed the two trillion US dollar mark. Another mindboggling sum. These massive reserves create a global liquidity (money) overhang that could easily feed into the next financial bubble, whatever form it might take, and the next financial crisis.

If the Fed continues to do “whatever it takes” to avoid a Japanese-style slump, as Chairman Bernanke has vowed, and it buys up a mountain of US Treasuries, thus keeping interest rates low, let’s be frank here: it is just running its printing presses, with the ugly consequence of rising inflation.

And if financial intermediaries jump into the breach? Then we merely have a somewhat more sophisticated version of plain-vanilla Fed monetization of debt, where banks score a nice, riskless profit by borrowing short at the Fed (a US government entity) at near 0%, and lending long to the Treasury (another US government entity) at around 3.5%. Moreover, as long as the difference between long interest rates on government bonds and short rates on the Fed’s liquidity lending remains this high, there is no incentive for financial intermediaries to lend to businesses and individuals. So this scenario could even lead to stagflation.

In sum, there is no painless cure for our debt problem. Each remedy has unpleasant side-effects. The not-merely-inconvenient truth of the matter is that the bill for “fixing” last year’s financial crisis is about land on the table with a very loud thud.

22/10/2009: Dollar, dollar, dollar...

Travel broadens the mind, they say. In my case, a recent tour of Germany, France, Belgium and the UK, attending client events and one-on-ones, has given me a valuable new insight that I would like to share with you now: Whatever the dollar does, we won’t like it.

Talking with clients, many questions that come up have a rather local perspective, understandably. But one of the most consistent concerns among clients everywhere I’ve visited lately is the weakness of the US dollar.

The dollar’s fate has also started to concern European decision-makers. In a flight of rhetorical gymnastics at which he is becoming increasingly adept, Jean-Claude Trichet, the European Central Bank President, stated, “I trust that it is extremely important that the US authorities […] will pursue policies that are taking into account the fact that the strong dollar is in the interest of the United States of America.”

After recovering from the whiplash induced by this gem of central-banker-speak, we note that it positions not one but two big elephants in the room. The first is that, without US dollar weakness, the global imbalances that led us, over decades, to where we are today will likely not diminish. The world simply cannot satisfy its growth ambitions by endlessly exporting to the US. Obviously, China comes to mind here as it is unwilling to let its currency appreciate against the dollar; but at least the Chinese authorities have boosted domestic consumption demand quite a bit, which can hardly be said of many European countries.

The second awkward truth is, in our view, the real cause of US dollar weakness today. Here, we must be careful not to mix the long term with short term. While it is true that the lax fiscal and monetary policies the US is currently practicing will likely keep the dollar on a depreciation trend, policies are not eroding the greenback today. Rather, it is the dollar’s role as the preferred funding currency for carry-trades – the investment strategy that calls for taking on debt in a low-yielding currency and buying assets in a high-yielding one – that is the immediate cause of the greenback’s weakness. The Fed’s commitment to prolonging low interest rates has made the US dollar even more attractive than the Japanese yen in carry trades now.

One lesson from the financial crisis is that carry trade activity is closely correlated with equity markets. If equities rally, carry trades also pick up; and if they correct, carry trades sputter. This leads me to recall another useful insight: be careful what you wish for; it might just come true. In this case, a stronger dollar could ultimately mean that stock markets are losing steam, a development that few would welcome.

16/10/2009: Money and inflation: putting the cart before the horse

“Inflation is always and everywhere ultimately a monetary phenomenon.” Often wrongly attributed to the late Milton Friedman, this comment reflects the conventional view of inflation as a continuous increase in overall prices. It presumes that what economists call the money supply must first grow before prices can move higher. In short, it argues that inflation is merely the symptom and money growth is its cause.

But this view ignores a sturdy pillar of Aristotelian logic – and common sense: a need (more money to pay higher prices) is not a cause. As a matter of historical fact, money growth does not automatically lead to inflation. Just look at the years between 1997 and 2007, when money grew at an astounding pace worldwide. Central banks’ reserves increased fivefold, and that only accounts for “visible” money. Last year, US Treasury Secretary Timothy Geithner estimated that the same amount of money held in “official” coffers could be found in the “shadow” liquidity of hedge funds, structured investment vehicles and other off-balance-sheet instruments.

Let’s recall that in 1998 these instruments were in their infancy. Thus, if Geithner’s estimate is correct, global money increased at least tenfold in a decade. But inflation was subdued during this period. In fact, its polar opposite, deflation, constituted enough of a threat for central banks to open the floodgates of liquidity creation on several occasions.

So, with all that money around, how come inflation was held at bay? There were several factors at work, but two prominent ones were the productivity surge from the information technology revolution – sometimes called “digital deflation” – and the rise of emerging markets as low-cost producers, well-known today as “globalization.”

Indeed, if it weren’t for the enormous money increase, these two factors would have assured deflation, but not the ugly, demand-driven deflation of the Great Depression and Japan’s Lost Decade. Rather, we would have seen a supply-driven version, something that has often occurred throughout history, most recently in the nineteenth century, whenever new technologies made things a lot cheaper.

Are digital deflation and globalization still at work today? According to the latest measurements, productivity gains are slowing now as the IT revolution matures. The promising technologies of the future (nano- and biotechnology, and energy sources like cold fusion, etc.) have not yet left the laboratory and achieved commercial scale. And globalization is no longer as deflationary as it once was. Emerging markets are shifting from low-cost labor suppliers to consumption competitors. They are no longer just lowering global prices through cheap production; now they are also raising prices through increased demand. This shift is already visible on commodity markets.

Moreover, after rescuing the global financial system and their local economies from the economic abyss, governments are set to play a much larger and more central role in economic affairs. Their active involvement raises the risk of a new era of protectionism. Meanwhile, tighter regulation of financial markets appears inevitable. Both of these developments could easily obstruct international capital flows.

So, while money growth alone surely would not lead to serious inflation today, other “horses” stand ready to pull prices higher in the future.

08/10/2009: The unemployment story and the stereotypes

In January 2003, just before the Iraq war began, US Secretary of Defense Donald Rumsfeld scolded what he called “Old Europe” as congenitally uncompetitive and old-fashioned while praising the region’s more dynamic countries that embraced the challenges of globalization (and war).

Donald Rumsfeld’s “Old Europe” was a coded epithet for France and Germany, while he saw England as a progressive role model. Economic proof of his worldview could be seen in the unemployment statistics at the time. For years, the jobless rates of France, Germany and Italy seemed frozen above 10%, twice as high as in the UK and the US. Meanwhile, between 1994 and 2007, Spain cut its unemployment rate from roughly 20% to less than 8% and “Celtic Tiger” Ireland from 16% to just above 4%.

Today, in the wake of the financial crisis, those trends have reversed dramatically. The UK’s jobless rate now hovers at around 8%, up from 5% in early 2008. And the US had to absorb a rather shocking September labor market report that put unemployment at 9.8%, its highest reading since the early 1980s and almost the double that of two years ago. Even more spectacular, Ireland’s unemployment rate currently stands at 12.5% while Spain’s is 18.9%. In both countries, these are levels last seen before their (credit-fueled) “growth miracles” began. Meanwhile, Old Europe’s labor markets have withstood the crisis far better, with unemployment rates rising only slightly, if at all.

Are these developments strong enough arguments to dismiss once and for all the Anglo-Saxon model capitalism as the one true path for economic development? We doubt it. The real test will come when economic momentum really picks up again. Then we will see whether the unemployment rates in the US, the UK, Spain and Ireland will fall as fast as they have risen, thus proving the case for their “flexible” labor markets. Meanwhile, without knowing the outcome of this challenge, the resilience we have seen in the major Eurozone labor markets lately is one reason why Europe remains our favorite region among the developed equity markets.

02/10/2009: Our Japanese future and the future of Japan

For outsiders, Japan is a land of mystery, formidable but opaque. Our perceptions are often little more than clichés that we try to apply, in vain, to an uncooperative reality.

In the 1980s, with its economy thundering on all cylinders, Japan was regarded with awe as the benchmark for management and productivity. Remember the wonder of just-in-time production, the much-revered circles of excellence? Back then, the Land of the Rising Sun basked in the economic glory of its crown jewels, the six Keiretsu. These vast, interlocking networks of companies – each with a big bank at the center of the web – controlled virtually all the strands of Japanese industry, guided by the omnipresent but impenetrable MITI.

Japan’s muscular business model was also feared. After all, they bought the Empire State Building and half of Hollywood and would soon, according to the worriers, overtake the US as the dominant global economy. In fact, the story did turn into a Hollywood blockbuster, but as a disaster film leading a prolonged period of stagnation known as Japan’s Lost Decade.

Some economists believe that Japan has still not recovered twenty years on. They attribute the country’s malaise to an economic policy apparatus that failed to adapt to a changing reality and thus was unable to take effective countermeasures. Hero worship is so fickle: yesterday’s invincible model is today’s “obvious” loser.

Not only that; some pundits see Western economies succumbing to the same paralysis that froze Japan’s economic juggernaut in the 1990s. But, as usual, we think reality is a bit more complex.

Rightly embarrassed by failing to foresee the big tsunami – the financial crisis unleashed by the burst housing and credit bubbles – a kind of Cassandra Complex has emerged among economists. Disaster lurks behind every data point. This time, despite the fiscal and monetary tools employed to comb the crisis – soaring government debt and oceans of new money printed by central banks –the West will still descend into its own Lost Decade. Or so they say.

We think that storyline is built on some false presumptions. In the US, and to a lesser extent the UK, the equation that ends up with the West repeating Japan’s Lost Decade is missing a crucial element: Japan’s steeply aging demographic profile. This factor explains a large part of Japan’s economic anemia since 1990. Despite all the talk, the US and the UK have still relatively young and, more importantly, growing populations. In this regard, Italy and Germany, with their declining birth rates and populations, may be susceptible to Lost Decadism, but the West as a whole is not.

And Japan itself? Here, a new myth has recently emerged: With the first real change in government in more than fifty years, the way Japan conducts its economic policy will also change, so the story goes. Instead of an export-driven economy, we will see the dawn of a new age of domestic and especially private consumption. Indeed, the new Finance Minister, Hirohisa Fujii, and new the Bank of Japan Governor, Masaaki Shirakawa, at first seemed to advocate that storyline, expressing the view that a strong yen could help the Japanese economy.

While it’s too soon to judge how this particular story will develop, it faces at least one daunting hurdle to a happy ending: again, demographics. We have difficulties imagining Japan’s senior citizens going on extended shopping sprees, and hence we remain skeptical about the country for the time being. The future of Japan could well end up repeating its recent past.

01/10/2009: The Nobel Prize season

With October, the Nobel Prize season is again upon us. As usual, the selections for the more political categories, peace and, to a lesser extent literature, will no doubt inspire controversy. Over the past couple of years even the economics prize has seen its share of contention.

Interestingly, economics was not named in Alfred Nobel’s original testament in 1895. The Economics Nobel Prize was first awarded only in 1969, called the “Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel,” to celebrate the tercentenary of Sweden’s central bank.

That economics is less of a hard science than its practitioners would have us think is reflected in the only slightly scurrilous jest that the Nobel Prize in Economics is best awarded to two people who have completely opposite views. This was actually the case in 1974, when Gunnar Myrdal and Friedrich von Hayek shared the Prize. Gunnar Myrdal was a Social Democratic member of the Swedish Parliament and then Trade Minister, while Friedrich von Hayek was a leading advocate of free-market capitalism.

The Nobel Prize for Economics generated another controversy in 1998, after LTCM’s bankruptcy almost brought down the global financial system. Two of that hedge fund’s co-founders, Robert C. Merton and Myron Scholes, had been awarded the Prize in 1997 for precisely the theories that led LTCM to take on too much risk and finally go bust.

So who will get the Nobel Prize in Economics this year? Actually, it’s easier to say who will not. It probably will not go to a macroeconomist, as they are currently licking their wounds after the financial crisis and in desperate need of a new conceptual framework. Nor is the Prize likely to go to an advocate of the financial sciences. Their workhorse, the efficient market hypothesis, is also exhausted after the rapid sequence of speculative bubbles and busts of recent years.

Behavioral economics might be a good candidate. The Prize already went to this promising union of the economic sciences, psychology and neurology in 2002, and the financial crisis has made it clear that more knowledge in this area is certainly needed.

Another contender could be environmental economics, which has not yet been honored by the Nobel Committee. True, the issue of climate change was acknowledged in 2007, when the Peace Prize was shared by the UN Intergovernmental Panel on Climate Change and Al Gore. But if the Nobel Committee were to recognize achievements in environmental economics with a Prize, it would not only be raising awareness of an urgent issue. It would also be making the sound point, in my view, that any solutions must ultimately involve economics, which is, after all, the study of choices and how they are influenced by incentives and scarcities.

24/09/2009: Japanese fables

For outsiders, Japan is a land of mystery, formidable but opaque. Our perceptions are often little more than clichés that we try to apply, in vain, to an uncooperative reality.

In the 1980s, with its economy firing on all cylinders, Japan was regarded with awe as the benchmark for management and productivity. Remember the wonder of just-in-time production, the much-revered circles of excellence? Back then, the Land of the Rising Sun basked in the economic glory of its crown jewels, the six Keiretsu. These vast, interlocking networks of companies – each with a big bank at the center of the web – controlled virtually all the strands of Japanese industry, guided by the omnipresent but impenetrable MITI.

Japan’s muscular business model was also feared. After all, Japanese companies had bought the Empire State Building and half of Hollywood and would soon, according to the worriers, overtake the US as the dominant global economy. In fact, the story did turn into a Hollywood blockbuster, but it was rather a disaster movie leading a prolonged period of stagnation known as Japan’s Lost Decade.

Some economists believe that Japan has still not recovered twenty years on. They attribute the country’s malaise to an economic policy apparatus that was unable to adapt to a changed environment and failed to take the right measures. Hero worship is so fickle: yesterday’s invincible model is today’s obvious loser. But, as usual, we think the reality is a bit more complex. Most specialists agree that Japan’s aging demographic profile explains a large part of the country’s perceived underperformance. Moreover, for those who have visited the country, it is very difficult to reconcile the stream of poor economic data over the last two decades with brisk and bright appearance of its cities.

Recently a new myth has emerged: With the first real change in government in more than fifty years, the way Japan conducts its economic policy will also change, so the story goes. Instead of an export-driven economy, we will see the dawn of a new age of domestic and especially private consumption. Indeed, the new Finance Minister, Hirohisa Fujii, and new the Bank of Japan Governor, Masaaki Shirakawa, at first seemed to advocate that storyline, expressing the view that a strong yen could help the Japanese economy.

While it is too soon to judge how this particular story will develop, it faces at least one daunting hurdle to a happy ending: again, demographics. We have difficulties imagining Japan’s senior citizens going on extended shopping sprees, but maybe we are too conventional. Although we will monitor Japan even more closely from now on, we remain skeptical about the country for the time being. In fact, we think it is one of the world’s most fragile economies at present. We find Japanese equities highly overvalued compared with European peers, or those of Asia’s emerging markets, even taking the latter’s higher risk into account.

18/09/2009: The US dollar's demise by 1,000 cuts

The Chinese authorities face a rather difficult, and potentially very hazardous, task. How can they reduce their US dollar dependency without hinting too much that they are doing so?

Remember, over the previous decade China has accumulated more than two trillion US dollars in foreign exchange reserves, most of it in dollar-denominated fixed-income investments like government and agency bonds. Until recent years, this dollar dependency and lack of diversification of these foreign exchange reserves were not thought to be problematic. However, the financial crisis and the way the US government and the Federal Reserve have reacted to it has made it clear that the well-being of US creditors ranks rather low on the priority list of the US authorities.

The Chinese are painfully aware of this. In March 2009, People’s Bank of China Governor Zhou Xiaochuan commented that: “An international reserve currency […] should be disconnected from economic conditions and sovereign interests of any single country.” This is clearly a requirement that the US dollar as the current major, if not only, international reserve currency is currently not fulfilling.

What can the Chinese do though? Just selling their dollar reserves for some alternative currencies and/or reserve assets, like gold, is not a viable option. Doing this in plain sight would tremendously weaken the greenback and hence the purchasing power of the accumulated Chinese reserves. This could result in a full-blown worldwide currency crisis and push the still-fragile financial markets back into a tailspin. Even worse, the surge of US and worldwide interest rates that would attend such a sell-off would increase the risk of a fall-back of the US and other developed economies into recession. This, in turn, would certainly lead the Federal Reserve to print even more money and thereby exacerbate the dollar weakness further.

For now, the Chinese seem to have decided to take small, almost innocuous steps. At the beginning of 2009, the Chinese started to sign swap agreements in yuan with several countries including Argentina, Indonesia, Malaysia and South Korea. In May, the Chinese and Brazilian Presidents, Hu Jintao and Luiz Inacio Lula da Silva, signed an agreement to drop the dollar for use in bilateral trade and instead use their local currencies, i.e., the yuan and the real. Finally, at the beginning of September, China announced it would buy notes issued by the International Monetary Fund and denominated in Special Drawing Rights (SDRs).

Another less direct way to reduce the dollar dependence stems from the fact that the Chinese government now explicitly encourages its domestic companies to use their earned dollars for mergers and acquisitions of overseas companies (especially in the energy and commodities sectors) instead of parking those dollars into US fixed income investments.

For the time-being, the sums involved are relatively small. The swap agreements involving yuan amount to roughly 100 billion US dollars, the bilateral trade between Brazil and China was somewhere north of 25 billion US dollars in 2008, the SDR investment will be around 50 billion US dollars and the ten largest Chinese direct investments overseas so far in 2009 were according to our estimates slightly below 25 billion US dollars. Those numbers are obviously dwarfed by the trillions of US dollars in Chinese foreign exchange reserves.

Nevertheless, one should not underestimate the power of symbolic measures. Following China’s SDR investment announcement, several other emerging markets, among them Brazil and Russia, also expressed an interest in an alternative reserve currency. While the days of the US dollar’s dominance as the unique world currency are not over yet, 1,000 small cuts have begun to scratch its shine.

04/09/2009: Hunting black swans

Parlous times often breed towering personalities. The Great Depression saw John Maynard Keynes become the leading economist and one of the most prominent public intellectuals of his generation and beyond. So far, the current crisis hasn’t produced anyone whose stature is comparable to that of Keynes. But there is one candidate who may someday join him in the economists’ pantheon, an individual who in any case will surely have a lasting influence on the profession of economics: Nassim Nicholas Taleb.

Taleb is one of the very few pundits who can fairly say, “I told you so,” in the wake of the financial crisis. His books, “Fooled by Randomness” and “The Black Swan,” have not only been bestsellers; they are truly seminal works in the theory of finance. Especially with “The Black Swan,” whose title has entered our everyday language, Taleb has become required reading for anyone who wants to dismantle the inherited inaccuracies of financial theory.

The main message of “The Black Swan” is that improbable, exceptional and extreme events occur far more often than we dare to think. The potent consequence of this conclusion is that reality is more complicated and unpredictable than we generally assume it to be. Black swans, by the way, were discovered in Australia in the 18th century and the book’s title plays on the assumption, employed in treatises on logic since Aristotle, that “all swans are white.”

The financial crisis is a splendid example of a fully-fledged black swan. Few thought such a meltdown was possible in the developed economies of the modern financial system; even fewer saw it coming. And now, after the fact, many economists are trying to save face by employing the kind of logical gamesmanship that Taleb so coolly punctures.

For example, some economists have adopted “hindsight bias” to suggest that the crisis was, of course, predictable; or they have succumbed to “narrative fallacy,” wherein an inexplicable event is folded neatly into a fluid story line to make it seem self-evident, albeit after the fact. Taleb’s point is that people, including economists, actively resist acknowledging that events can overwhelm their comfortable cognitive preconceptions; they (we) are highly creative and all-too-successful at painting any disturbing black swans white, which is how we like them to be, after all.

Add to this the media’s penchant for airing extreme opinions rather than more moderate views, and the aftermath of the financial crisis has the punditocracy spouting a steady stream of doomsday scenarios. It seems that since most economists were wrong-footed by the crisis, none wants to miss the next black swan, which is certainly swimming out there somewhere.

But this creates a paradox: If black swans really are sighted everywhere, then they are no longer exceptional. Grim predictions invoking runaway high inflation, or a deflationary, Japanese-style paralysis, or the impossibility of central banks smoothly exiting their stimulus programs, or the catastrophic consequences of the massive new debt on government balance sheets are becoming the norm. But the norm, by definition, cannot be a true black swan.

Indeed, the black swan today would be the scenario of a seamless return to the “great moderation” of the previous 25 years, with low inflation and high growth. Admittedly, this is a highly improbable, even extreme prospect after such a profound crisis. But bear in mind, extraordinary events are not necessarily negative in nature and black swans must not always be bleak.

21/08/2009: Perseverare diabolicum

One of the biggest public blunders in the history of economics was committed by Professor Irving Fisher a few days before the stock market crash of 1929, when he stated: “Stock prices have reached what looks like a permanently high plateau.” At the time, Fisher was probably the most famous economist in the US, a scholar who made lasting contributions to interest rate and monetary theory. Had a Nobel Prize in economics existed back then, he surely would have won it, such was his repute.

The Crash of 1929 effectively demolished Fisher’s outstanding academic career. He died largely forgotten in 1947, with the Keynesian revolutionaries already well entrenched in university faculties. This is more than sad, since in 1933 Fisher published one of the most brilliant analyses of the deep causes of the Great Depression in an article that is still well worth reading today.

Another not so good call was made in September 2007 by Professor Robert Lucas. While the signs became more and more clear that the US and by extension the rest of the World were sliding into a major financial crisis, he stated in an op-ed of the Wall Street Journal: “I am skeptical about the argument that the subprime mortgage problem will contaminate the whole mortgage market, that housing construction will come to a halt, and that the economy will slip into a recession […] If we have learned anything from the past 20 years it is that there is a lot of stability built into the real economy.”

Like Irving Fisher back in 1929, Robert Lucas is also one of the leading economists of his time with path-breaking contributions especially in business cycle and growth theory, which earned him the Nobel Prize in economics in 1995. His rational expectation revolution set itself as a task to put the macroeconomic theory, which was until then based upon ad hoc modeling, on sound rational bases. It actually drew the macroeconomic research agenda for the last thirty years.

No wonder that many economists, including the author, who studied during this period, feel now, after the financial crisis somewhat lost. Clearly the mathematically elegant models failed to forecast the financial crisis but this is not what is so bothering about them. Robert Lucas in a recent contribution to The Economist, correctly states: “One thing we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September.”

What is really bothering though is that such models were obfuscating a far more complex reality. When Fed Chairman Ben Bernanke was still in 2005, just before the prices peaked, denying the existence of a housing bubble or when Fed Chairman Alan Greenspan explained back in 2002, that “it was very difficult to definitively indentify a bubble [in US equity markets] until after the fact”, they both built their judgment upon exactly those models.

If there is one lesson to be learned from the crisis, it is that those mainstream macroeconomic models are useless when it comes to exuberance or to deflate bubbles in the making. New, more farsighted models are needed.

Not everyone seems to agree here, though. In the same “The Economist” contribution, Professor Lucas stresses: “[…] the futility of trying to deal with crises and recessions by finding central bankers and regulators who can identify and puncture bubbles.” To err is human, but to persist is devilish.

24/07/2009: You can never leave

With its sweet Mediterranean climate, great wines, and world class skiing, it’s a popular destination for tourists around the world. With its 1.8 Trillion US dollar GDP, it is the eighth largest economy in the World. It’s part of a currency union and considered by many – especially outsiders – to be ungovernable and basically broke. If you’re thinking Italy, think again, because I’m referring to California.

Of course, that wasn’t exactly fair. When taking a first glance at the finances, California does not look at all like Italy. Its outstanding debt in form of General Obligations is currently in the neighborhood off 60 billion US dollars. This is at best a rounding error when compared with Italy’s government debt, which hovers somewhere above 2.3 trillion USD. But, remember, California is not a sovereign nation and therefore isn’t burdened with the usual governmental big ticket budget items like defense and a the majority of social security expenditures. Once you take this into account, California’s looming 2009 budget deficit, at a projected 24 billion USD, is even more worrisome than the 100 billion dollar deficit that Italy is likely to face.

So defining California as the Italy of the US is not so far fetched after all. What is puzzling though is that no one seems to notice the 800 pound golden bear in the room and ask whether California should trade in the US dollar for its own currency? This is a case that many investors — especially outside of Europe — are lightly making not only for Italy but for all other “PIGSI” nations (the acronym stands for Portugal, Italy, Greece, Spain and Ireland, all members of the Euro-Zone and confronted with heavy government deficits).

When you think about it, there is not much upside for those countries to leave the euro (or, for that matter, California to leave the US dollar). Yes, having flexible exchange rates would probably allow those countries to export more to their former currency partners and even to other countries, since their currencies would depreciate. A similar phenomenon happened after the UK had to leave the European exchange rate mechanism back in 1992. However, those countries would also be confronted with much higher interest rates on the debt expressed in a new currency and an old debt still denominated in euros. This would make the burden especially expensive if not plainly unbearable. The recent fate of Iceland, which had to default on its debt and wants now to join the Eurozone, comes to mind.

If there is not much incentive for countries with debt and deficit problems to leave a currency union, there might be at least some incentive for sterner member countries to kick the profligate out. Many New Yorkers remember the 1975 Daily News Headline: “Ford to City: Drop Dead,” when then-US President Gerald Ford menaced that he would veto any bail-out of Big Apple. In fact, despite already having to pay higher interest rates than the average Eurozone member, PIGSI nations might still weigh on the overall euro interest rates and exert a negative externality on the public finances of countries like Germany, Austria or the Netherlands. But this negative effect is more than counter-balanced by the reality that if PIGSI countries were kicked out of the currency union their currencies would devaluate and the remaining countries would see their exports crumble. The same argument would apply if one of the more sober countries decided unilaterally to leave the currency union.

To make the case against a break-up of the Eurozone, therefore, you don’t need an international treaties lawyer. I believe that Italy like the Golden State will ultimately remain in its currency union or to quote the last verse from The Eagles’ this time: “You can checkout anytime you like, but you can never leave!”

10/07/2009: Hard questions for a soft science

If a modern economics journal fell open at your feet, you might be amazed at all the mathematical formulas it contained. Numbers nerds argue that only elaborate mathematical models can illustrate economic truths, while the numerically challenged counter that the math papers over a lack of pragmatic ideas. Either way, neither bashing nor praising Wall Street’s quants, those unloved scapegoats of the current financial crisis, is my purpose here.

Given its mathematical basis, economics can fairly be regarded as a science, but it is surely not a “hard” science like physics or engineering. For one thing, no experiment can really test an economic hypothesis—leaving aside the trials where university students are paid to respond irrationally to microeconomic questions.

History is economics’ only laboratory, the only arena where its empirical results can be judged. And the idea that history repeats itself probably applies more to its lessons than its details. Going by how often the word “unprecedented” has been invoked in connection with the crisis, it follows that history can offer us only limited guidance now.

Legend has it that Thomas Edison made 10,000 duds before managing to produce a working light bulb. Obviously, depending on the complexity of the challenge, mastering something new can be extremely difficult. Thus, as an economist, I am astonished at the public’s faith that the world’s central banks and governments will somehow succeed, in their very first attempt, to steer us clear of depression, deflation or downright disaster, getting us gently back on track, unharmed and inflation-free. I find this optimism naive.

Many parallels have been drawn between the current crisis and the one that followed the stock market crash of 1929. Back then, the Fed and other monetary authorities remained inert and it took the US government four years to start the New Deal. Most economists think that this inaction turned the crash into the Great Depression.

This time around, central banks have been quick to respond, massively increasing their balance sheets and unleashing a flood of fresh money into their economies. Governments have launched large, even “unprecedented,” stimulus packages that will thrust public deficits into the stratosphere.

However, given the universal lack of experience with this kind of rescue operation, especially on such a grand scale, no one can honestly pretend to know how much monetary and fiscal expansion is enough, and even worse, how much of it can safely be withdrawn once the crisis finally passes.

In physics, elasticity is the property of a material to return to its original shape after having been deformed. If too much force is applied, the deformity will be irreversible. The hard question now is whether the economic damage is still reversible or has the deformation been too large? While we can answer this empirically in the hard science of physics, in economics, unfortunately, those who apply the remedies can only guess. History’s verdict awaits us.