Saturday, August 2, 2008

Good ole fashioned Keynesian stuff!

Paul McCulley of PIMCO wrote a great article called The Paradox of Deleveraging. The reason I think it's great is because it's completely wrong, but in a way that makes me smile. It explains the broken Keynesian view of the economy and the recession. It prescribes what the Keynesian-minded central bankers must do to fix our problems. McCulley is mostly just talking his book as PIMCO has invested heavily in the prescriptions he favors. Of course, these are the same theories that Bernanke and Paulson subscribe to, so it's no surprise that this is what we have been getting and will continue to get. My favorite quote from the article: "Good ole fashioned Keynesian stuff!"

Here is a good rebuttal of McCulley's view. It is in line with the Austrian school of thought.

Personally, I don't worry as much as I used to about this stuff. When I initially learned about the Austrians, I worried so much about all these government policies that were obviously wrong. Bad policy created terrible asset bubbles and then prescribed the wrong medicine. Reading authors such as Hayek, Hazlitt, and Rothbard was a great revelation for me. I felt compelled to campaign for Ron Paul, the only person in Congress who truly understands these issues. We had some successes along the way, but we weren't able to convince the American people. They have not yet woken up and they are such easy victims for people like Bernanke and Paulson who are more than glad to privatize the profits and socialize the losses under the guise of saving the financial system. Just look at Fannie Mae and Freddie Mac. One cannot fathom a better bailout -- while the Treasury sends them money to keep them solvent through the front door, they can continue paying dividends to their investors out the backdoor. Well, the Democrats and Republicans just love them too much. No surprise though -- they donate handsomely to their campaigns and the politicans can support them under the cover of trying to keep housing affordable. Right, housing was so affordable when prices were increasing exponentially. Well, maybe after another 30% to 40% drop, it will finally become affordable. Of course Fannie and Freddie will be doing everything in their powers to stop that.

After the Paul campaign started winding down for me in January, I realized how much all this economic knowledge was useful for investing. This influenced my decision to short and buy Jan 09 PUTs (bets that the price will drop) on Fannie and Freddie in Febuary. I later closed most of these positions just before the bailout was announced. During this period, Fannie's stock went from $28.70 to $8.55 and Freddie from $26.61 to $6.83.

The principles of Austrian economics predicted how this asset bubble would play out (the asset prices would eventually drop and the most leveraged participants would become insolvent) and the principles of Keynesian economics predicted what the Federal government would do about it (bailouts for the GSEs and the banks). Anybody who says that Austrian economics isn't practical surely didn't consider its application for investing. Of course timing is also critical. Austrian economics predicts what will happen but it doesn't make claims about the timeline.

I'd much prefer that we had sound money based on gold and I could invest in productive companies that create value for the economy and provide dividends to their investors. But since this government has taken that option away from me and continues to erode the value of the dollar through inflation, my only alternative is to make money by exploiting these bad policies. My one big fear though is that the entire financial market self-destructs and the dollar crashes with it. I think there's around a 10% chance of that happening. In that event, we're all going to be poor. In that scenario, I just hope I have enough gold, water, and food to weather that storm and come out the other side with enough to invest in the new economy that emerges from the ashes.

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