Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

26 August 2015

A Dozen Reasons for a Global Bear Market


[For an update on gene editing as the possible source of a transformative new industry, click here.]

1. China really matters
2. China is slowing down
3. The other BRICs are slowing down, too
4. Slow growth is developed nations’ destiny
5. The oil glut will continue
6. Global trade is slowing down
7. Whole new industries are unlikely to appear soon
8. Sustainability is lurking, if not starting now
9. The chickens of our bloated and lawless financial sector are coming home to roost
10. Fear of inflation precludes a regulatory correction
11. The fear stampede already has begun
12. Fear stampedes come in waves, as in 1929
Conclusion
Update on Gene Editing (8/30/15)

Is the recent global stock-market crash a temporary blip or a trend? As always, it’s hard to tell. But there are a number of reasons why we all may already be in a sustained, global bear market. Here they are, in rough order of importance:

1. China really matters.

China matters a lot, probably even more than we Yanks do. China has the world’s number-two economy, and it’s still on track to become number one. It also comprises nearly a quarter of our species.

With China’s growth slowing, its becoming number one may take a few years longer than now expected. But growth is still stronger at 7% than at 2.8%. And remember, we’re talking about exponentials. Since before the Crash of 2008, China has been, by far, the chief engine of global economic growth.

2. China is slowing down.

There are five reasons why China is slowing down. First, it has to. Consistent growth at 9% is unsustainable, not to mention extraordinarily hard to manage politically. Second, China is aging, in part due to its now-weakening one-child policy, which (by the way) has been, and still is, absolutely necessary for China’s economic rise.

Third, China is turning inward. Its primary economic policy today is converting China from dependence on international trade to a modern consumer economy like ours, in which our own Yankee consumers account for 68% of GDP.

Fourth, China’s entrenched and intractable culture of corruption is holding it back. Xi is making some progress in fighting corruption, but it’s still not enough.

Finally, while Xi is enlightened in some respects, he is centralizing power, and the instincts of the people he has put in charge of China’s economy seem retrograde to genuine market reforms. The reflexive “prop it up” reaction to the first big stock-market crash in China is probably just the tip of the iceberg. With all these problems, China’s growth may be even slower and more erratic than now expected.

3. The other BRICs are slowing down, too.

They have different reasons, but the trend is marked. Brazil is corrupt and mismanaged. Russia is not as corrupt but equally mismanaged, and Russia is far too dependent on oil, which is in glut.

India is perennially a nation with an “enormous potential” that is proving highly resistant to realization. There are reasons for this: before 1947—less than 70 years ago—India wasn’t much of a country. It was a collection of vastly different rajas and principalities, with different languages, cultures, histories and governments. It’s still trying to pull itself together, and Narendra Modi’s history of tribalism doesn’t help much.

4. Slow growth is developed nations’ destiny.

Developed nations’ economies are “mature.” Their populations are rapidly aging. So slow growth will be their fate for the foreseeable future. This includes us Yanks.

Some growth can come from smoothing out growing economic inequality. But developed countries have nothing like China’s (or India’s) potential in this regard. China alone has several hundred million poor peasants waiting to be urbanized and integrated into a modern economy. The only possible sources of renewed growth in developed nations are: (1) financial Ponzi schemes like the one that caused the Crash of 2008; (2) recovering from catastrophes, for example, a nuclear war or environmental catastrophe; or (3), on the good side, massive investment in sustainability, which may be starting but hasn’t yet taken hold.

With developing nations slowing down, and developed nations basically stagnating, where’s high growth going to come from? Mars?

5. The oil glut will continue.

It’s a simple matter of supply and demand. Supply exceeds demand. With global growth slowing, that fact will likely persist for some time.

OPEC, which still controls the global market, might cut production, but it has developed a habit of discipline. More important, only a few nations—Saudi Arabia, Iraq, Iran and Russia—have sufficient reserves to affect global pricing all by themselves. Russia and Iran can’t because of political sanctions and foreign antipathy. Iraq is still fighting a civil war and a war with IS. And the Saudis don’t want to cut production.

If the Iran deal is consummated, and if Iran observes it long enough to see the back of sanctions, another huge flow of excess oil supply will come on the market in about six months. Then oil prices will tank further. Or, as that moment approaches, oil markets may adjust, and prices may drop more gradually.

6. Global trade is slowing down.

Generally speaking, international trade is a good thing. Besides war, trade is the only way foreign cultures deal with each other on a sustained and daily basis. Of the two, trade is more pleasant.

But global trade is succumbing to powerful modern trends: sustainability, localization, protection of jobs, and protection of food security. It wasn’t the abomination that I call “pay for rules” that has killed the TPP. It was the slowly increasing craving for more local control over jobs and food, among other things.

Today the “locavore” movement is not just a matter of upscale restaurants. In an era of increasing angst about energy and food security, it seems more sustainable and efficient to grow food and make heavy things like cars closer to where they are used.

There are more reasons than just jobs and food security to source things locally. Centralization is generally bad human social organization, as the collapse of Chinese and Soviet Communism proved. In contrast, diversity is the general rule of biological health and survival.

So doesn’t it make sense to grow and make things all over the world, in distributed farms and production facilities, rather than growing and making them in huge, centralized industrial complexes and then shipping them all over the world? Isn’t the latter approach like the old, Soviet centralized heating system for the whole City of Leningrad, whose failure, not too long ago, froze heroes?

7. Whole new industries are unlikely to appear soon.

Among our species, sustained global growth spurts have come from radically new technologies, which spawned whole new industries and industrial clusters. Coal power and assembly lines sparked the Industrial Revolution. Oil, electricity, automobiles and aircraft, as well as electromagnetic communication (telephone, radio and television) sustained it for another century. So did modern medicine, which vastly increased our population and longevity and is still doing so.

Yet despite our species’ massive recent investment in R & D, there’s nothing comparable happening today. Few, if any, of the “innovations” of the last thirty years are “transformative” in the same way that those mentioned in the previous paragraph were. Even the Internet is not.

Sure, the Internet makes commerce and industry more efficient. But it’s likely to be far more disruptive in politics, international relations and the arts than in industry. Uber and Airbnb don’t create whole new industries. They just steal trade from cab drivers or hotels and short-term apartments, respectively, plus expand those businesses and make them more efficient. They are variations on a theme. Even the Tesla is similar: it’s just another automobile, albeit one which has a more flexible and ultimately sustainable source of energy.

Really transformative new industries are still on the drawing boards. One might be affordable private space travel (SpaceX and Virgin Galactic). Another might be nuclear fusion in a bottle. A third might be genetic modification of children, so-called “designer babies.” Some day we might design children smart enough to support sustainability, and not to watch Fox!

On our species’ way up from fire to sustainable energy from the wind and Sun, we’ve often charged ahead only to discover serious unintended consequences. So far, unforeseen consequences have included (among many other things) the “Silent Spring,” Chernobyl, Fukushima, the global spread of atmospheric radioactivity before the nuclear test ban treaties, and massive air pollution in cities, the worst of which today probably lurks in Beijing and Shanghai. Today, even little things also harass us, like the nanobeads used in soap and perfume that are now cluttering the bottoms of our lakes and rivers and appearing in the fish we eat.

Unintended consequences were a lot less dangerous when our technologies were less powerful and we were much less numerous. But now that we number over seven billion, and now that we can raise about a billion people out of poverty in one generation, we have to be more circumspect. A wrong turn—for example, a reversion to coal power—could spell horrible suffering for our species. Add to that the fact that we’ve already eaten the low-hanging fruit of species-wide, radical industrial transformation, and it’s hard to see how “innovation” is going to sustain otherwise unsustainable growth.

Don’t get me wrong. Innovation will continue and probably accelerate. But it will become more and more “technical” and incremental, i.e., smaller scale. We’re unlikely to see, at least anytime in the next decade, new industries as economically and socially transformative as steam engines, electricity, electromagnetic communication, the automobile, the computer, or the airplane.

8. Sustainability is lurking, if not starting now.

One of the oddest things about our species is our quaint notion that we can keep growing, in population and economic impact, virtually forever. Biologists know what happens when any species outgrows it habitat. There is a euphemistically-named “population crash,” caused by disease, starvation, predation, environmental disaster, ecological collapse, or conflict, which in our case means war.

Despite having Sir Thomas Malthus’ only-partly-right prediction for well over two centuries, we humans still think the normal rules of biology don’t apply to us. In that respect, we’re all sort of like Hillary Clinton and her private e-mail system as Secretary of State.

But perceptions are changing. They are changing so slowly they’re like watching grass grow or paint dry. But changing they are, especially among the young, and especially in big cities in developed nations.

There are so many aspects to the change that it’s hard to name them all. But here are a few: (1) population control in China and slowing of the population explosion elsewhere, (2) the push for renewable energy and conserving fossil fuels (which the present oil glut will counteract), (3) the slow transition to non-industrial-scale and sustainable agriculture, in part to escape food-borne diseases (4) the “locavore” movement for sustainably sourcing food near where it’s eaten, and thereby enjoying fresher and tastier food, (5) the trend of “hip” young people to live in cities, in smaller dwellings with more walkable amenities, and (6) the trend among young urban dwellers toward using public or shared transportation, including shared bicycles and cars, instead of owning personal vehicles.

Many of these trends, of course, will spawn or promote new industries. Renewable energy is perhaps the most salient example. But, generally speaking, they reflect a desire of our globally aging population, and even our young, to “downsize.” Once these trends reach fruition, if they ever do, the result will probably be a “smaller” global economy, with smaller GDP numbers and less frenetic international trade, but with generally happier, safer and healthier people. People’s lives will become richer and better, at the cost of less impressive economic statistics.

9. The chickens of our bloated and lawless financial sector are coming home to roost.

We Yanks and developed economies put far too much money, effort, brainpower and people into financial “products” and investments and their automation, which do little but exacerbate volatility. Someone should do a study of the increase in financial-“industry” employment since the Crash of 1929. It would probably look like the hockey-stick graph of increasing atmospheric carbon dioxide: a slow and steady increase for decades, followed by an inflection point and an exponential rise, probably beginning somewhere in the mid to late eighties, just before the orgy of deregulation that led to the Crash of 2008.

What do all those people do? Do they assist so-called “capital formation,” funding new real businesses and startups with new ideas to do real things? Not hardly. The vast majority of what they do is speculation, which our tougher-minded Yankee pioneer forbears would call “gambling.”

Even we geezers are in on the game. With interest rates at rock bottom, we can’t just put our considerable collective cash hoard in banks. And there aren’t (yet?) enough public venture-capital firms for us to assist in capital formation. So we participate in the general orgy of speculation, directly through investments in stocks or bonds or indirectly through mutual funds.

Two very, very smart people have warned us about all this, one just two days ago, and one eighty years ago. Two days ago, Mohammed El-Erian, under interview on PBS, pointed out that all the extra “liquidity” our Fed and other central banks have injected into the global economy has raised the prices of assets (stocks and bonds, and even real estate) artificially. (His view does not contradict my view that central-bank generosity has not sparked inflation in the prices of goods and services, because goods and real services are different from financial assets and act differently.)

Eighty years ago, the great economist John Maynard Keynes penned a short essay absolutely nailing what drives the financial “industry.” It’s not long-term investment in real business, which is difficult and risky and gets no one rich quick. Instead, it’s speculation.

The financial minions all work on a single principle: they can get rick quick, or have a decent chance of doing so, not by predicting economic growth or industrial direction, or by investing in startups, but by beating small investors like you and me, or each other, to the punch.

It’s all reminiscent of the old joke about two men in the wild threatened by a bear. “I don’t have to outrun the bear,” one says to the other. “I just have to outrun you.” And so it is with bear markets.

That’s the basic principle on which the financial “industries” operate, and which Keynes articulated eighty years ago. Today the people who feed this beast are more numerous, more powerful, and more wealthy than ever before. They make money as bulls or bears; they thrive on volatility. And they have all the tools of modern computers, high-frequency trading, lax (and sometimes clueless) regulators, and favorable tax rates. You think all this is going to end soon or well?

10. Fear of inflation precludes a regulatory correction.

What saved our species from the Crash of 2008—besides our various central banks—was a vital, practical distinction between real goods and services, on the one hand, and financial investments on the other. I have written a whole, long essay on why the central banks’ largesse didn’t spark inflation. In essence, geezers like me, plus corporations, absorbed the excess liquidity but didn’t spend it, at least not on goods or services, which would have raised their prices. Instead, the hoarders invested in financial instruments, raising their prices. That at least, is what Mohammed El-Erian says.

But now the central banks are out of ammo. They have no room to lower interest rates to spark real economic activity because interest rates are, already and artificially, at rock bottom. They’ve been there since the Crash of 2008. On the other hand, central banks can’t raise interest rates, as Janet Yellen has been threatening to do all year, because doing so would exacerbate the deflationary trends driven by Points 1 though 9 of this essay.

Raising interest rates would not only deflate the asset bubble. It would impair credit for real goods and services—the lifeblood of commerce and international trade.

So the Fed and other central banks are stuck, helpless, without ammo. All they can do now is what used to be called “jawboning,” leaving The Markets to the same conditions of lawlessness and caprice that ruled in 1929 and 2008. The Fed can prevent the Masters of the Universe and their “too-big-to-fail” banks from taking on excessive risk, and it is doing so. But that doesn’t prevent the rest of us sheep from stampeding.

11. The fear stampede already has begun.

In an earlier essay, I introduced the notion of financial “stampedes,” as a better metaphor than a “bubble.” Financial catastrophes entail two kinds of stampedes. The first is a greed stampede, which inflates the prices of assets.

Greed stampedes are usually slow. They build up over a long period of time, as regulations get lax and more and more people besides financial professionals join the get-rich-quick party.

The great financier Bernard Baruch saved his fortune by selling out in 1929. Why? He detected the near-climax of the First-Gilded-Age greed stampede when his cab drivers starting offering him stock tips.

What follows the greed stampede, as night the day, is the fear stampede. In it markets plummet, some sell out, and many are ruined. That, I think, is what started happening a week or so ago.

Now fear stampedes happen much faster, and are much more dangerous, than greed stampedes. They are nearly impossible to stop. At least they were in 1929 and 2008.

Today we have three relatively new phenomena that make them even harder to stop. First, financial investment is far wider spread than ever before; reportedly half of us Yanks own stocks or bonds individually or through mutual funds. Second, financial professionals are more numerous, more powerful and richer than ever before. Whether right or wrong in fact, they all believe that they can profit from beating you and me, or each other, as the bear approaches. Finally, we have the utterly new phenomena of multiple parallel electronic markets connected to secret and antagonistic trading algorithms, which which the pros now try to beat each other, you and me.

12. Fear stampedes come in waves, as in 1929.

One reason the “stampede” is a much better metaphor than the “bubble” is that financial crashes and panics depend first of all on human perception and reaction. They’re like a bit of smoke or small flames in a crowded theater. Some nervous folk smell a whiff or see small flames and head for the exits. Some sit in their seats, thinking “it’s just some bozo lighting up” or “a grip will appear with a fire extinguisher.” Others just wait and see, while still others fear the risk of being trampled or hope someone will save them until they start to feel high heat. Then they bolt.

And so it is with financial stampedes. The pros—at least those who want to be out—are already out. Others want to ride the inevitable successive waves of “bottom-feeding”—buys by optimistic folk amongst the generally downward trend. No doubt they have tuned their trading algorithms accordingly.

The rest of us are individual and corporate small investors lacking our own proprietary trading algorithms. Some of us have smelled strong smoke and sold out already. I’m among them. Others are waiting and seeing.

Sure, there will be rallies. There are always optimists, and transient opportunities to profit on the upside will appear. But markets can take time to reach bottom. After 1929, it took about four years. Today, with far wider ownership, a 24-hour news cycle, and electronic, algorithmic trading, it could happen a lot quicker.

Some still credit the near-universal advice of pros: in the long run, markets revert to the mean, and stock and bonds make money. But as that selfsame John Maynard Keynes once said, in the long run we are all dead.

Right now, an unquantifiable but huge hoard of cash is in a geriatric money pit. Like me, its owners are closer to, and more conscious of, the truth of Keynes’ point. Their “long term” is shorter than others’. Some of them will no doubt heed the pros’ incessant calling for patience and fortitude as they race to win. A lot more, in my view, will sell out. They will do so in waves, depending on their awareness, risk aversion, and attention, as the bear approaches.

Not everyone, even in small and medium-sized businesses, reviews his or her portfolio every day. But people are doing that now. You can tell by the long waits and occasional “busy signals” you get when you try to access your broker or mutual fund online. But as more people do review their wreckage, and as more awareness spreads, you can expect more selling. That’s just human nature.

Conclusion

Notwithstanding alleged improvements in governance, we’re not really much safer than in 1929. Like military leaders always fighting the last war, the regulators can’t ever catch up. Sure, we have limits on margin buying—the most obvious and immediate cause of the Crash of 1929. Sure, our markets are generally better scrutinized by regulators and more orderly and systematic.

But our regulators and even pundits are way behind in two respects. First, no one has come to grips with multiple, parallel, electronically-connected markets, let alone the automated, high frequency trading algorithms that now run them.

No one, least of all regulators, has the big picture. In the real world of computers, a system like that, with multiple, antagonistic programmers constantly throwing software out, mostly in secret, would have to be tested for months or years before being allowed to “go live.” If that’s happening, or even beginning to happen, in our electronic markets, I’m Napoleon. Regulators, including the SEC, just don’t have the time, patience, staff, technical expertise or situational awareness.

So the law of unintended consequences is now the most important law governing our collective financial future.

The second big risk is derivatives. They’re still out there, to the tune off somewhere between $500 and $700 trillion. No one knows for sure, not even the Fed. Many of these transactions are still secret, with no public accounting; they are made in so-called “dark pools.” Due to heavy lobbying by bankers and the general obscurity of the subject, Dodd-Frank hardly touched them.

Our only real bulwarks against a repeat of the Crash of 2008 are the pros’ own greater awareness and risk aversion and the Fed’s higher capital-reserve ratios. If turmoil in stock and bond markets bleeds over into the huge and largely secret market for derivatives, we may have a Second Great Depression. If so, it will be global.

So sleep robustly, my children. By “robustly,” I mean with courage. There is no wise and benevolent regulator looking after your interests. As in 1929 and 2008, you are mostly on your own.

I’m writing this essay as an exercise in thinking out loud, and to reward the small cadre of faithful readers of this blog. I have mostly put my money where my mouth is: I’m now about 85%-90% in cash, guaranteed funds and a single, ultra-low-volatility non-REIT real-property fund of directly owned properties.

So I’m out in the fresh air, away from the smoke and flames, with a fire extinguisher in my hand, standing aside from the likely path of the nascent stampede. Where are you?

Update on Gene Editing (8/30/15)

I wrote the foregoing post before reading The Economist’s review of the nascent science of gene editing, The Economist, Aug. 22, 2015, at 19-22. The new CRISPR-Cas9 technology, which permits selective gene editing, has potential applications well beyond “designer babies.” Indeed, designer babies are its most difficult and most controversial application and therefore among its least explored. More pedestrian applications include: (1) discovering the functions of human, animal and plant genes, the vast majority of which are unknown, (2) modifying food animals and crop plants to improve their yields, resistance to pests, growth efficiency, nutritional value and taste, (3) modifying disease vectors and other pests, such as mosquitoes, so they cannot carry diseases or are otherwise less harmful, and (4) correcting genetic deficiencies in humans, other animals and plants, i.e., curing genetic diseases.

Already at least half a dozen startups have formed to explore and exploit these techniques, and they are fully capitalized. And already there is a battle royal over patenting, with a patent application for the basic technology vying against an issued patent for its use in animals and plants. For technology historians, this titanic battle will recall the contest among Alexander Graham Bell and other alleged inventors for control over the telephone. (At the Supreme Court, The Telephone Cases spawned an entire volume of the Supreme Court Reporter (with that title)—the only single legal dispute ever to have achieved that distinction.)

In the long term—perhaps even in the medium term—this technology could become transformative. It could change agriculture, medicine, industry and society as much, for example, as did the Bessemer converter to make steel, or the discovery that you can make electricity by rotating a coil of wire inside a magnetic field (or vice versa).

What are its implications for employment? At first glance, it might seem that the principal beneficiaries would be PhDs in microbiology, a relatively small group. But we humans have 20,000 genes each, and every animal or plant has a similar order of magnitude. It’s unlikely, although possible in theory, that the process of gene editing could ever be fully automated. So this nascent industry will need plenty of skilled and semi-skilled labor, including: (1) lab technicians to do the editing, test the results, and (if successful) bring them up to industrial scale; (2) industrial workers to effect industrial-scale gene editing and the distribution of its products; (3) farmers to test and exploit the results in agriculture; (4) engineers and industrial workers to produce the enzymes and genetic chemicals, and the laboratory equipment, to practice the technique, and (5) all sorts of guards, inspectors and monitors to ward off unintended consequences, such as a modified crop seed or food animal getting out prematurely into the wild, or into a productive, non-experimental farm.

In a mere four years, this burgeoning field has exploded from around 100 to around 1,000 scientific papers annually. It could easily produce new industries within the next five years, almost certainly within the next ten. Then gene editing might become the new computer programming—another way to manipulate information, this time genetic information—to improve our lives and our control over ourselves and our environment. Indeed, we might eventually come to think of gene editing as biological programming.

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