Econ 101, Bonds, Quantitative Easing, Cucumbers, and Irrational Exuberance

“Rates down, good for bonds, rates up, bad for bonds. Excellent!  Rates down – let’s trade!” That was the extent of Andy’s analysis, and I took this as the signal to hit the phones and start stuffing bonds into my investors’ portfolios in Scandinavia, Kuwait, Benelux, etc.

I kid you not, this incident took place over 20 years ago when I was a young Eurobond salesman in London. I remember this exchange as if it were yesterday. (Eurobonds in those days were US Dollar denominated bonds issued by borrowers outside the US.)  I was one of the elite salesmen selling off Andy’s positions of various European government issued, mostly AAA rated, Dollar denominated sovereign bonds to anyone interested in buying them, and buy they did, big time  It was easy to make money.  We waited for market data, hit the phones for a couple of hours, waited for the brokers to start taking prices off screens around 12 noon, which was a signal for lunch.  After a three-hour lunch spent with other traders, salesmen, brokers, and investors we made it back (some slightly worse for the wear) to the office to close our positions, tally up our gains and losses and head back to the wine bars in the City of London either to celebrate, or drown our sorrows. A true story.

I liked Andy a lot.  He was a breath of fresh air, a kind of a person I had never come across in my life before. He was full of life and always happy and optimistic. He had no formal education. Had he not been a bond market maker he would have made a great living by selling cucumbers at a market stall in East London. Andy looked like a spiv, a real Arthur Daly.  He wore wide pin striped suits.  His satorial sense was always combined with white socks in black shoes, scuffed may I add. Indeed, he took pride in always wearing a fresh pair of white socks on Monday mornings. In contrast, I was an economics graduate from one of the finest fresh water schools in the US, dressed in my repressive Brooks Brothers suits, white button downs and tasselled loafers. I had sweated through calculus, linear and matrix algebra, econometrics, comparative economic systems, and God only knows what else.  And here was a dude who was running a book in millions with the skills of a market trader.  I am sure that Andy though of me as a bit of a “plonker” but he never said that, and I admired his fearlessness.

I have no idea what came of Andy, but I am sure he has done well for himself and his family.  He probably shorted the cucumber market and made a mint.

The reason I wanted to give this very personal monologue is that nothing has changed since the 1990s in terms of human behaviour.  The market has again hit unprecedented highs until yesterday when the Japanese stock market fell by 7 per cent.  The Keynesian economists and politicians think that national economies can be moved at will.  The collapse of the world banking system in 2008 caused a recession that saw a fall of 50% in world stock markets. Keynesian economists have convinced politicians that markets and economies can be controlled through centrally planned policies. How wrong they are!

In the US and the UK central banks have cut interest rates to almost zero and pumped money into the economy through a money printing programme.  (Money printing is now called as “quantitative easing.”  It is my opinion that quantitative easing is no different from printing money.  J. A. Schumpeter described the printing presses in Austria where one could hear the machines and the heat of the machines on the outside wall the central bank. Today, central banks press a button on a computer, but the effect is the same.)

My hero, Andy, would agree that printing money is good for investors.  As yields fall, bond prices go up.  Furthermore, investors in equities will see the value of a firm’s future earnings increase.  I learned this in Econ 101 and Andy would instinctively know about this relationship. What is not taught in Econ 101, however, is how quantitative easing enters the system.  Andy would explain this by using an analogy of syrup being poured on a table.  Syrup  enters at some point in a system and it takes a long time to spread across a table.  By the time the syrup reaches the end of the table it is just a thin film.  So it is with quantitative easing.  The money enters the financial system and the majority of the benefits are accrued by institutions and investors close to the monetary entry point.  This money gets invested in securities that creates an asset bubble.  In the meanwhile, the people and the firms at the edges of the table can only hope for the little film of syrup.  Governments are aware of this effect and they try to develop policies to force banks to lend money to the real economy.  Well, have you to ever responded to a central dictate how to behave in terms of your individual investment behaviour? No, me either!

Once the stock market is out of control, predictably, central banks begin to signal that they will need to take the heat out of the economy.  But what is this economy?  It’s an economy that has been built on quantitive easing that has been channeled to markets.  In the meanwhile, the real economy has been starved of cash.  The central banks will raise interest rates to take the heat out the market.  And guess what?  The real economy gets whacked.  I learned this in Econ 101 and my friend Andy knew all about this.  It’s no wonder that economics is known as a dismal science.  To an extent I am proud to call myself as an economist but I do not want to be associated with economists who are walking us to another major fall.

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