Why common sense is often the best response .

The writer Mark Twain wrote almost 50 books and yet is almost certainly better known for his aphorisms. The pithy one liners that combine folk wisdom and common sense are such that even ones he didn’t write are attributed to him, such as the one from Voltaire, that, “Common sense [the essence of Twain] isn’t that common”. For investors, however, perhaps one of the best is, “History doesn’t always repeat itself, but it often rhymes”, since one of the things we learn from history is that people are too often guilty of assuming that history repeats itself exactly. 

Currently, we see the three biggest problems facing Western economies as arising from exactly this issue of overly precise models that not only ignore Twain’s dictum, but also Voltaire’s. The triple threat of  zero interest rates, zero Covid and zero carbon has arisen from the models developed by the Federal Reserve, the WHO and the UN respectively, models that have been assiduously applied by national governments, even as they have failed to deliver anything but unintended consequences.

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Thus, as the collective West followed the Fed in lowering to somehow ‘stimulate inflation’, we saw inflation everywhere but the high street. Twain’s common sense would have pointed out that people relying on cash savings to live would not go out and spend more as rates fell as the models ‘predicted’, they would instead save more, just as they had done in Japan. It might also have pointed out that an artificially low cost of capital would prop up zombie companies, and keep an excess supply of goods and services that would keep prices lower, rather than higher, as well as the fact that the carry trades in capital markets were driving speculative bubbles.

Then zero Covid saw the extrapolation of overly precise modelling about the death rate that led to a literally unprecedented shut down of the world economy, disrupting supply chains and leading to a dramatic increase in fiscal spending. While initially there was a perceived cost benefit, it rapidly became clear that the models were providing an overly precise output based on imprecise inputs and that they didn’t reflect what was actually happening. Here again, the central banks ignored the rhyming of history and even their own previous models from the 1970s and 1980s, and essentially monetised that fiscal spend through a massive increase in the money supply, something both history and their own models should have told them was the one thing that absolutely would create inflation. Clearly not their ‘new’ models, however, for they continued to dramatically loosen monetary conditions, while monitoring only the current inflation rate, rather than accepting the lags in response to policy.

The tacit acceptance that the Covid models were wrong led to an opening up of economies as rapidly as they were closed. This had the (common sense) impact of creating transitory inflation as demand exceeded temporarily restricted supply, but it wasn’t until the lagged effect of the 40% increase in the money supply in 2020/21 started feeding through in 2022 that the Fed and other central banks finally recognised the problem. Too late, they have not only started raising rates, but significantly reduced the growth of the money supply, such that in the US it is now negative. Once again, their own models should have told them that this will cause a sharp slow-down some time in the next 12-18 months.

Into this mix of policy error and unintended consequences we can now add zero carbon and zero imports (from Russia). The former has led not only to a huge under-investment in the traditional energy sector, which despite decades and literally trillions of dollars invested in so called ‘green’ energy, is still responsible for over 80% of global energy consumption, while the latter – the sanctions in response to Russia’s invasion of Ukraine – has left Europe in particular at serious risk of enforced de-industrialisation, as well as a long cold winter. Mark Twain’s folk wisdom and common sense would have pointed out that wind and solar are unreliable, and need fossil-fuel standby power which, thanks to the closure of coal-fired power, could only come from imported gas. He would have pointed out the need for storage and long-term contract pricing from reliable counter-parties, as well as questioning why fracking and nuclear were not allowed, while shipping wood pellets thousands of miles to burn in power stations was somehow more sustainable.

The other Mark Twain quips that should perhaps be observed by investors are that, “When you find yourself on the side of the majority it is time to pause and reflect”, and as applies to risk: “It’s not what you don’t know that kills you, it’s what you are certain you do know that turns out not to be so”. The notion that, possibly due to the certainty that history repeats itself, investors fail to recognise that often the biggest risk to the portfolio is the one thing you believe to be risk free. As such, he would have pointed out to investment consultants and pension-fund trustees that simply measuring risk in terms of volatility and benchmark tracking leads to a targeting of both that leads to hidden risk elsewhere, principally in the form of illiquidity and hidden leverage. He would likely have pointed to any number of carry trade collapses from history that ‘rhymed’, from LTCM in 1998 to credit default swaps a decade later, with any number of smaller events in between.

However, as Twain observed, “It is easier to fool people than convince them they have been fooled”, and thus the best route for investors is to acknowledge that the modelers will continue to assume a precision they do not have with a conviction that we should not share, but that precisely because policymakers fail to learn from history or the fact that it rhymes, they will continue to do ‘the wrong thing’. This is the background against which we have to make our own decisions.