Central Bank Actions, Uncertainty, and Diversification

Central Bank Actions, Uncertainty, and Diversification

If some is good, then more is better.  That’s the way simpleminded people think.

Think of alcohol.  A little is good, but past a certain point, more is bad.

I think about central banking the same way.  Until recently, quantitative easing seemed to stimulate the economy, but each increasing dose has done less.  The last one seemed not to work at all, and long rates rose amid buying of bonds by the Fed.

The same applies to running deficits.  Perhaps the Keynesian solution works when there is adequate borrowing capacity in the private sector, but when many cannot borrow more, running high deficits may scare businessmen and consumers, because they wonder whether the system is stable or not, how the books will eventually balance, etc.  Inflation, deflation, higher taxes, currency depreciation… there are so many possibilities.

The leaders in simple-mindedness are Ben Bernanke, and Shinzo Abe of Japan.  Add in George Bush, Jr., and Barack Obama — deficits don’t matter.  They are like Fat Freddy with a hammer; every problem looks like a nail, and he will whack it with his hammer.  BAM!  It’s better, right?

Economies are complex because people are complex, and groups of people are even more complex.  The simplistic tools of neoclassical macroeconomics do not work in situations where there is too much debt, but the ideologues display confidence to the watching world.

When this pattern breaks it will be ugly, and I don’t know when or how it will be ugly.  It all depends on whether policymakers move to inflate or deflate.  You might say, “Of course they will inflate.”  Many thought that in the Great Depression, and they were wrong.

My main point here is that we all know less than we think about the future.  We have no idea as to what might finally derail the policy monoculture of the dominant nations — large deficits and loose monetary policy, but it will derail, and how it will resolve is a mystery.

So diversify your asset allocation into things that benefit from inflation and deflation — maybe you will keep something after the crisis hits.  After all, the looser monetary policy is, the worse the adjustment when the tightening comes, and monetary policy has never been looser than this since 1790.

By David Merkel, CFA of Aleph Blog