The Not-So-Invisible Hand
ADAM SMITH, THE father of free-market economics, wrote about an “invisible hand” in his magnum opus The Wealth of Nations, published in 1776. The invisible hand, which guided resources and capital to where they would be most productive, is one of the best-known images in economic literature. In Smith’s words, man “neither intends to promote the public interest, nor knows how much he is promoting it . . . He intends only his own gain . . . led by an invisible hand to promote an end which was no part of his intention. . . . By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”1
Smith was, of course, the major figure in the development of laissez-faire economics, the purest form of free enterprise. He was strongly opposed to monopolies and cartels and warned repeatedly of their “collusive nature,” which would fix “the highest prices which can be squeezed out of buyers.”2 Smith also warned that a true laissez-faire economy would quickly become a collusion of business and industry against consumers, which would scheme to influence politics and legislation. So things seem to have turned out pretty much as Adam Smith foresaw.
The last few decades of the twentieth century and the first decade of the twenty-first were a time of economic experimentation for the United States—not at the command of big government or as the result of a clamor for change by the general public but as a result of the great American belief in the power of free markets. This faith was amplified by many leading economists and financial professionals and championed by both Republican and Democratic administrations from at least the time of Ronald Reagan.
Intrinsic to that faith in the market is trust in the operation of an “invisible hand” to guide buyers and sellers to the best possible outcomes. Whether it is housing, autos, construction equipment, goods at Wal-Mart, or products available from online retailers, the market mechanism adjusts supply and demand to reach fair prices, equitable distribution, and socially beneficial results. At any rate, that is the basic theory.
But is the invisible hand currently all that, well, invisible?
In short, some market participants are greatly tempted to “help” the invisible hand reach outcomes favorable to their own personal interests and wallets. This is the sort of anticompetitive behavior and market monopolizing that has been resisted with only partial success in the U.S. economy for generations.
Adam Smith clearly understood the dangers of monopolies and the necessity of their regulation—unlike our Mr. Greenspan, who as we saw in the preceding chapter, despite his reverence for the master, seems to have been more influenced by the school of absolute economic freedom espoused by Ayn Rand. Ironically, the founder of laissez-faire theory would be likely to side with the old trust-busting policies of Teddy Roosevelt in addressing these problems. We saw where Mr. Greenspan stands on this one.
Though the era of unfettered deregulation now seems over, one debate between the invisible hand and the helping hand, if you will, remains as fiercely fought as ever. That is the issue of “free trade.” A cause célèbre of long standing, it’s now an issue amplified by the concerns of a global economy, and how it plays out in the years ahead will have a formidable potential to enhance or disrupt every investor’s holdings, whether domestic or foreign. When it comes to investing, there’s no doubt that it’s a global world, with an unprecedented level of interconnectedness among the major economies.
Given the world we must deal with, there are two subjects that should be of particular concern for all investors in trying to protect their investments in the global economy. These are the investment implications for the future of free trade (with the related conundrum of fair trade) and the ominous signs of future inflation, the monetary dragon that can never be permanently slain.
The Case for Free TradeNaturally, Adam Smith was a strong believer in free trade. He opposed the efforts of Alexander Hamilton, our first secretary of the Treasury, to put up barriers to protect the United States’ infant industries in the early 1790s, as he was convinced that the country would benefit more by the open export of cheap agricultural commodities, where it had a strong comparative advantage.3
The law of comparative advantage has been the core of free-trade belief for almost two hundred years. It was first put forward by David Ricardo, an English economist, in 1817.4 Ricardo used the example of England and Portugal to illustrate his thesis: Portugal can produce wine and cloth more cheaply than England. But in England wine is very costly to produce while cloth is only moderately more expensive. Even though it’s less costly to produce cloth in Portugal than England, it is cheaper still for Portugal to produce more wine and trade that for English cloth. Portugal then has more of both. England also benefits from this trade because its cost of producing cloth is still the same but it can now get wine at a cheaper price, coming out better on the deal. Thus each country can gain by specializing in making the products in which it has a comparative advantage, and trading that good for the other.5
Free trade has been one of the most debated topics in economics for the last two hundred years, on economic, moral, and sociopolitical grounds. A recent survey in this country showed that as many as 65 percent of those surveyed were against it. Surprisingly, in high-income groups the percentage is even larger.6
In the last few decades, numerous new theories have come out that favor or disfavor free trade. The law of comparative advantage has been challenged, even by numerous new hypotheses that favor free trade. Paul Krugman writes: “Free trade is not passé, but it is an idea that has irretrievably lost its innocence. . . . There is still a case for free trade as a good policy and as a useful target in the practical world of politics, but it can never again be asserted as the policy that economic theory tells us is always right.”7
Are We in a New Era of Free Trade?There is one area where the invisible hand continues to face fewer restrictions in this country, even though it sometimes functions poorly. That is free trade. Ricardo’s thought, which was true in his time, was that the masses in the Far East and other remote, underdeveloped regions would never be a part of the international labor force. In any case, even if they could be, the cost of shipping raw materials to them and finished goods back to Europe would make the final prices prohibitively high. In the last six decades, however, technology and skilled labor in those nations have turned what was true in the early nineteenth century upside down. Ease of transportation, highly skilled and educated workers, and easy movement of machinery to any country have dramatically lowered the costs of production in Asia and elsewhere.
The result is that higher-wage countries such as the United States are at an enormous disadvantage relative to their low-paying counterparts. In 2008, the average U.S. hourly pay was $18.00. When benefits of $3.60 an hour, including the Social Security tax of 6.2 percent, are added, the average U.S. working hour costs the employer about $22.90. Compare this figure with the average wage in China in 2008 of $2.00 an hour, in Indonesia of $.65 an hour, in India of $.41 an hour, and in Thailand of $1.67 an hour.8
The cost of one hour of labor of a Chinese employee is less than 9 percent of the cost of a U.S. employee. In fact, the Social Security tax on the average U.S. hour worked is almost two-thirds of the average Chinese worker’s wage and more than three times the average Indian worker’s wage. Taking this a step further, in a perfectly competitive world, if there are 150 million workers in the United States and two billion in China, India, Indonesia, and other low-wage Asian countries, the average wage for an American worker manufacturing the same product would have to drop very sharply to be competitive: from $22.90 an hour to a small fraction of this.
This is a worst case scenario, as many jobs obviously cannot be exported, but unfortunately, it contains far more than a grain of truth. It is the reason we are outsourcing millions of our best jobs abroad and will continue to do so in the future. Ricardo could not foresee the future, and most contemporary economists have not focused directly on this problem, which has a number of thorny aspects.
To begin with, American consumers, along with those in almost all countries, want lower-priced goods of equal or even higher quality. This demand fueled the rise of Wal-Mart from a start-up forty-five years ago to the largest chain in the country today. The Wal-Mart revolution has spread to thousands of other businesses in dozens of sectors, all of which must make or sell low-cost products.
Second, low-cost foreign labor allows many businesses to stay competitive with foreign firms. The U.S. auto parts manufacturers were at a competitive disadvantage for years because their foreign counterparts could supply parts at lower prices. The American Big Three had to force a good number of suppliers to open plants in Asia or be dropped. Building plants abroad was the way to survival for many hundreds of industrial companies.
Increasing cost pressures on other industries, plus the natural desire to increase profit margins, have also led U.S. business to use lower-cost services abroad. India, where English is the second language and often the first, is a natural provider of these services. Customer service is provided there for dozens of companies, from United Airlines’ reservation, departure, and arrival information to American Express’s credit card information to hundreds of other companies’ customer service help lines. All displace American jobs at significantly lower wages. But the range of services can also be much broader and more sophisticated: U.S. firms needing software engineers can get the work done for about $10,000 a year in some cases, against the annual cost of $80,000 to $90,000 for a U.S. engineer. Brokerage firms can ship over the daily processing in some departments after the market closes and receive the completed results early the next morning. A good deal of routine accounting can also be e-mailed to India, with the completed work returned promptly at a much lower labor cost.
Although parts of the country are up in arms about illegal aliens crossing our border from Mexico and taking minimum-wage jobs away from Americans, government at the federal level somehow seems less concerned about our losing much higher-paying skilled jobs to Asian and other lower-paying countries.
Obviously, unrestricted free trade is good for consumers and business buyers because it keeps their costs down and should also dampen inflation in many manufactured products. But is it good for the country? Not necessarily, if in the end we lose millions of jobs because of the enormous disparity in wages. If the loss of jobs is significant enough, our purchasing power will go down as a nation and our standard of living will decline. We will be able to buy fewer goods regardless of the prices they are selling at.
The unemployment rate was 9.1 percent in September 2011. Unofficially, including people who are self-employed not by choice, part-time employees, and those who have dropped out of the labor force because of frustration at not finding a job, it was estimated in September 2011 to be 16.5 percent, not much lower than at times during the Great Depression.
For the United States, this could prove extremely damaging. By knowingly exporting high-paying jobs, we are confronting a situation never faced before on a scale of this magnitude. The cost of high unemployment, the social unrest that goes with it, and the continuing erosion of our industrial base could more than offset the benefit of lower-cost imports. Meanwhile, lower import costs here, while threatening our own standard of living, will certainly increase the standard of living of China, India, the Pacific Rim Tigers (Taiwan, Hong Kong, Singapore, and South Korea), and other low-wage countries.
We have the choice of intentionally lowering our standard of living, which we are now actually considering—witness an independent committee proposal to the president in late 2010 to reduce Social Security and other benefits and raise the retirement age over time, as well as the dismissal of teachers and policemen across the country because of lack of funds to pay them. Or we can take affirmative action to protect our standard of living.
The last but most important part of the picture is that almost no country—not even the United States—is really a free trader in the Ricardian sense of the term. Free trade is in reality an economic myth. Most nations are fair traders to a greater or lesser degree. Fair trade usually consists of trading partnerships or alliances based on negotiation, transparency, and dialogue, with the goal of greater equality in international trade. It attempts to offer better trading terms and conditions to cooperating nations as well as securing the rights—read protection—of marginalized producers and workers. Fair traders open their markets to some extent but make sure their workers are not seriously affected. Many countries, including our major trading partners in Asia, such as China, India, and the Pacific Rim Tigers, are certainly questionable even as fair traders.
China is a classic example of unfair trade practices today, just as Japan was twenty-five years back. Like Japan in the 1980s, China is pursuing an export-led growth strategy, limiting domestic consumption, encouraging saving, and guiding investments into strategic industries. It has a multitude of trade barriers and an undervalued currency. It also carefully protects its major markets, where it is at a large competitive disadvantage relative to U.S. competition, by means of a multitude of skillfully constructed trade barriers. A prime example is the financial industry, where the United States has a significant cost advantage. Restrictions on ownership of financial companies and a myriad of other barriers keep the United States from exploiting this. The same protection is used by many other countries to restrict U.S. access to their financial industries.
There are many industries where restrictions are placed on sectors in which the United States or another highly developed nation has a competitive advantage, particularly in service industries and technology. When this occurs repeatedly, we have a new board game called “Free Trade.” The object is to parrot the words “free trade” continually while obtaining the largest trade advantage possible. It is like Monopoly in the sense that the winner takes all, but in this version, it is the nation that gains the largest continuing trade surplus by taking in the largest amount of foreign currency that wins.
Adam Smith would call the current trade situation neomercantilism, and from his writings and his letters to Alexander Hamilton, we know he would be strongly opposed to it. About a quarter of The Wealth of Nations was devoted to arguments against mercantilism, meaning a policy of protectionism that spurs exports while limiting imports. Free trade cannot exist unless all trading partners subscribe to it, and this is a virtual impossibility in today’s world. Would Adam Smith expect any one nation to adopt free-trade policies in a world that does not? I would doubt it, as his was a multinational, not a single-nation, theory.
The United States is not unaware of the game or its tactics, but our major players change with every new administration, while our most wily competitors keep their ALL-STAR trade negotiators playing for their countries for decades. The way the United States is playing the game must be of serious concern. In recent trade negotiations with South Korea, President Barack Obama offered it the opportunity to build its own jet engines in its own plants in its own country, with U.S. help. If the offer was serious, we would be giving away an industry in which we still have a strong comparative advantage, as well as state-of-the-art technology. This action could allow South Korea to become a low-cost exporter, possibly increasing our trade deficit further and costing us even more skilled jobs.
In late January 2011, General Electric, one of the aviation industry’s largest suppliers of airplane technology and jet engines, inked a deal for a joint venture in commercial aviation with a state-owned Chinese company that will share its most advanced airplane electronics, including technology used in Boeing’s state-of-the-art 787 Dreamliner. China is seeking technological support in the world’s most advanced industries to eventually challenge the best from Boeing and Airbus. Leading technological industries in highly developed countries are trading off their technological expertise for a share of what they hope will prove to be a gigantic Chinese market.9 The larger the number of advanced companies that play this game, the faster China will probably leap ahead in the development of ultrasophisticated technological products that are likely to increase its exports and reduce the exports of countries with high standards of living. Moreover, the Pacific Rim Tigers, as well as other neomercantilist countries, are also adept at this new variation of “FREE TRADE,” exacerbating the problem further.
China’s commitments to strong protection of intellectual property rights are far more often breached than observed. To make matters worse, the Chinese outright piracy and replication of U.S. intellectual property, from computer software to CDs and DVDs of music and entertainment companies to video games to top-of-the-line fashion, runs into the tens of billion of dollars a year. A Bloomberg article estimated in 2010 that the dollar value of pirated software from 2005 to 2009 doubled to 7.58 billion dollars. According to Microsoft Chief Executive Officer Steve Ballmer, “China is a less interesting market to us than India, than Indonesia.”10 One source estimates that of the millions of copies of Microsoft’s Windows used in China, only about 20 percent are purchased; the rest are illegally replicated there.11
With millions of Chinese entering the ranks of the middle class, knockoffs of such luxury brands as Prada, Louis Vuitton, Burberry, and Rolex are widespread and widely distributed. Movies and other intellectual property of media giants such as Time Warner are also continually pirated, along with those of the music and computer game industry.12 The Chinese go one step further by not allowing distribution of more than several dozen U.S. movies, all censored, in Chinese movie theaters, whereas the United States allows them to distribute theirs here at much lower royalties.
Unfortunately, the problem does not end here. We are not only exporting jobs to China and other countries with very low-cost wages. Many thousands of other U.S. jobs are lost primarily to China through counterfeiting. Our patents are blatantly ignored, and Chinese workers manufacture American and other industrial countries’ products by simply making the goods in China and ignoring patents and copyrights. The magnitude of the counterfeiting is significant. Estimates peg the Chinese counterfeiting at approximately $480 billion worth of goods annually, much of which comes from the United States. The amount is 75 percent larger than the entire U.S. trade deficit to China, which was $273 billion in 2010.13 Although the sums are enormous, they have received little media exposure. Senator Carl Levin stated at the Congressional Executive China Commission hearing, “The Chinese government itself estimates that counterfeits constitute between 15% and 20% of all products made in China and are equivalent to about 8% of China’s annual gross domestic product.”14 The statement was reiterated by Wayne Morrison, Specialist in Asian Trade and Finance, in a Congressional Research Service Report prepared for Congress, January 2011.15
China has thus also taken by illegal means many high-quality jobs out of our country and other industrial countries and given them to its own workers, presumably at a much lower cost, by ignoring patents and licenses. As a result, counterfeit goods are a not insignificant part of the Chinese economy, and have proved costly to both U.S. labor and U.S. industries.
Although the Clinton, Bush, and Obama administrations have attempted to stop these and other unfair trade practices, even going to the International Court of Justice, almost no progress has been made. Other factors, including political considerations such as Iran, North Korea, and global warming, mitigate the United States’ desire to use stronger tactics.
We also continue to have other major disputes with China. For example, China has turned a deaf ear to our urgings to raise the value of the Chinese currency to a more appropriate level, which would increase our exports to them and decrease our imports. Similar negotiations are going on with several dozen other countries having large trade surpluses with the United States.
How should we deal with these problems—or can we? The most serious is our high rate of unemployment and the question of whether it will become chronic. In the past ten years no new net jobs have been created domestically, while U.S.-China trade alone has eliminated or displaced 2.8 million jobs, as well as others to the Asian Tigers and other low-wage countries, all of whom are not free traders. As noted, figures coming from the Obama administration state that 25 percent of the job losses since the 2007–2008 recession are expected to be permanent. Moreover, the accelerating trend of outsourcing U.S. jobs abroad is showing no sign of abating, which could mean that our unemployment rate will continue to stay high over time.
The shortfall of jobs in the United States is the most significant problem the country has faced in decades. In the four years since the recession began, the U.S. working population has grown by about 3 percent. Jobs in a healthy economy would have grown by the same amount. Today the country has 5 percent fewer jobs than before the last recession began.16
There are certainly ways to bring about change. The United States is still a country blessed with almost all the natural resources it needs, other than oil,*93 as well as the strongest manufacturing and technological base that has ever existed. We could play the trade game the way most countries, including those of the European Union, do by expanding and improving our negotiation capabilities and forcing countries with large trade surpluses to open their important but now restricted markets. There is very little that the Chinese or the Pacific Rim Tigers manufacture that we cannot.
Employing a stronger fair-trade policy, the United States could also erect temporary trade barriers against nations that refuse to open up important markets or that indulge in large-scale piracy: theft of our intellectual property or other products. The penalties would have to be rigorously enforced with major fines or other damages. If the penalties weren’t paid, we could perhaps slap on tariffs until they were. This is, of course, only if we could put aside political considerations.
Likewise, with China and other low-wage countries, if we demanded that they adhere to some minimal environmental, worker protection, and employee medical and benefit standards, these standards would raise their labor costs, helping to decrease their exports to us, perhaps significantly. This is dangerous ground and measures other than environmental standards are probably best not approached by the federal government. But we have flirted with such ideas before, with respect to restrictions on child labor and to the strong, effective embargo that was placed by companies, unions, and individuals on South Africa before blacks were given the right to vote in the 1980s.
Similarly, we could follow up with tax credits for companies that increase employment domestically. We could also decrease tax benefits to U.S. companies that continue to increase employment of workers abroad or raise the tax when such firms want to repatriate their earnings unless these funds go into creating jobs in the United States. To date, neither of the two previous administrations, nor any economic theorists, have really taken on or acknowledged the depth of the problem.
Government policy over a number of administrations has helped destroy our auto industry. For almost thirty years our cost per vehicle was $1,500 to $2,000 more than that of foreign competitors. Foreign companies that were not unionized used cheaper labor, while our domestic companies could not. They were also given tax incentives by various states that wanted them to locate in one of their areas. It was only after the bankruptcy of GM and Chrysler that the playing field was finally level, at least for the moment. Ironically, no other major manufacturing country that I can recall has given foreign companies a major competitive advantage in an important home market. Our policy for decades of maintaining unionization for domestic producers, while allowing foreign manufacturers in the United States not to be unionized, puts our domestic auto companies on the chopping block.
The United States cannot be the sole exponent of the very liberal fair-trade policies we practice without the serious consequences discussed. If we continue on our current fair-trade course, we will see an enormous transfer of wealth from the pockets of our citizens into those of China and other Third World countries and quite possibly suffer from chronic unemployment in the process. It’s certainly not a problem we want to face, but not facing it is likely to make it progressively worse with time.
At this time, such actions seem nearly impossible, but times change. If high unemployment remains a serious problem, and little on the horizon indicates that it will not, the fallout from this will affect and alarm increasing numbers of voters. We are seeing a glimpse of this in the demonstrations and crowds camping out near Wall Street and in a number of American cities, as well as in mounting numbers of cities in Europe. The internal political pressures for full employment will mount, and with them the demands for changes in trade policy. Neither political party will be likely to want to oppose this challenge. Whether in two years or five, it is likely that a U.S. administration will eventually start promoting more aggressive policies toward fairer trade.
Adam Smith and David Ricardo both wrote about the merits of free trade. Would they have considered the current problems this nation faces here simply a matter of disagreement among trading nations? I doubt it—particularly when the wealth of the nation, its labor force, is being systematically put out of work or forced to take lower wages. That’s how we’re managing to freely trade in our high standard of living for something less, especially for our children.
The Case for Future InflationInvestors have come out of the Great Recession frightened, battered, and with their confidence shaken, if not shattered. How could it be otherwise? What we went through was not a recession but the second worst depression in the nation’s history. Economists do not currently use the term “depression” and have not used it since 1945, no matter how bad the downturn has been. The D-word has not been used since the 1930s—not a bad application of Affect theory by economists, but hey, knowing the beating they would take if the D-word had to be used again, it’s been any port in a storm.
But whatever the official name of what investors have been through, we are hopefully better armed, with our new psychological tools, than the average investor to deal with what lies ahead. We know the risks of forecasting, something almost nobody can do with precision. We also should remember from chapter 14 that stocks and real estate, along with other similar investments, do very well over time.
What most of us also know (and would not like to remember) is that our government is running some of the biggest budget deficits on record. This is true not only on an absolute but on a percentage basis: $1.4 trillion in 2009 (fiscal year ending September 30), $1.3 trillion in fiscal 2010, and $1.3 trillion in fiscal 2011, plus more than $2 trillion in other Federal Reserve and Treasury bailout costs and monetary stimuli. The Treasury printed and continues to print enormous amounts of dollars. For a benchmark to measure it against, the entire TARP bailout of the banking system, which has been repaid, totaled $700 billion, or about 12 percent of the money the Treasury has already printed to meet the budget deficits, potential bailouts, and monetary stimuli.
Deficits will continue to push upward if the divided Congress does not cut spending or raise taxes to the tune of $700 billion plus a year. Now that the first waves of terror of the Great Recession are fading into the past, investors are beginning to look beyond sheer survival to what comes next.
What seems likely, even if employment continues to increase at a very modest pace, is that we will see inflation, perhaps modest for the first few years but then accelerating at a more rapid rate. It is not only the United States that has bailed out its economy but most of the world. Stimulus funds to China accounted for $2.1 trillion, the European Union for $500 billion, South Korea for $117 billion, Russia for $111 billion, Brazil for $80 billion, and Canada for $58 billion.17 Money is being printed on a worldwide basis.
Notably, one of the precursors to actual inflation is the movement in the price of gold. From late October 2008 to the end of August 2011 the price of gold rose $1,117, or 156 percent. Oil and commodity prices have also surged ahead during this same period of time: oil by 42 percent, copper by 149 percent, wheat by 54 percent. The world is awash in currency, with the likelihood that the printing presses will continue 24/7 for months to come, if not longer.
What should the smart investor do? First, not what many frightened investors have been doing: selling their stocks and putting the proceeds into Treasuries or bank accounts. In fact, that’s the last thing any knowledgeable investor should do today. We have seen how bonds and T-bills outpaced those investments in the period following 1945. With the lowest interest rates since the Great Depression, this is almost undoubtedly going to happen again and hurt large numbers of investors. After 2007–2008, it’s like jumping from the frying pan into the fire. Moving heavily into Treasuries or other bonds will seriously compound the damage to portfolios.
During the Great Depression, the deflationary environment protected and increased bond prices until World War II. The situation today is very different. With the rekindling of inflation and a low to almost zero interest rate on Treasuries, the probability of sharp losses to Treasuries, T-bills, and other fixed-income securities—as chapter 14 demonstrated—is high; just how high, we’ll see shortly.
I believe we are likely to have a period of very high inflation, possibly as bad as what the nation went through from 1978 through 1982, because of the enormous increase in our money supply since 2008. Printing money is also not likely to stimulate the economy because interest rates on the short end are already touching zero. This appears again to be the typical questionable decision making we’ve seen from the Federal Reserve in recent decades. Strong opposition exists to the Federal Reserve’s buying back Treasuries and, in the process, borrowing more money, in the face of strong criticism from most of our major trading partners. These include not only the Chinese and Russians but also the European Union, particularly Germany and the United Kingdom. Brazil and other emerging economies also fear that by loosening credit the Fed could cause new destabilizing asset bubbles abroad.18
The international fear is that this is a blatant attempt by the Fed to weaken the dollar, thereby improving our exports and decreasing our imports. In the process it can cause higher U.S. inflation and, if other countries follow by printing even more money, higher inflation globally.19 Given this situation, if we had only one trading partner, China, this might be a tool to lower our trade deficit with it, but with well over a hundred trading partners, it is a very dangerous tactic and one that is unlikely to succeed. The outcome would be only more virulent inflation.
In 1978–1982, prices rose at an almost unprecedented 9 percent annual rate. At their worst, long-term Treasuries yielded as much as 15 percent while short-term rates touched 17 percent. To take a worst case, let’s assume that the 1978–1982 rate of inflation is repeated and bond yields duplicate those back then. Investors owning a thirty-year Treasury today would see the interest rate rise from 2.9 percent (the September 2011 level) to 15 percent. Treasuries would drop 63 percent, including interest received. But inflation would gobble up another 53 percent of the bonds’ purchasing power, so that investors would have only about 17 percent of their original purchasing power left at the end of five years, and that is before taxes on the interest. As you can see again, long bonds are a disaster in this situation. Remember, the shorter the maturity, the less you lose if inflation becomes virulent.
If you agree with this analysis, stay with the recommendations of chapter 14. Stocks will do perfectly well, as they always have done. Studies show that they do well even in periods of hyperinflation. Some years back, Jeremy Siegel, the author of the excellent book Stocks for the Long Run, sent me a number of charts, at my request, of how stocks performed in periods of hyperinflation, from the Weimar Republic in Germany in the 1920s to inflation in post–World War II Brazil and Argentina. The purchasing power of those countries’ currencies was as little as one-billionth of what it had been previously. Remarkably, in all three cases, after an initial decline for some months, the indices not only adjusted for inflation but also performed considerably better, in line with the Dow and other indices in major industrial countries.
In a depressed market, such as the one we’re still in today, we don’t have to hit a home run each time at bat. We will do very well by investing in a market index fund. If you believe that contrarian strategies do work over time, you will get significantly higher returns by buying a large, diversified portfolio of contrarian stocks, as chapters 11 and 12 showed, providing much higher returns than the market for decades. Real estate and art are also good hedges for the period I believe we are about to enter, but you have to know what you’re doing. Gold will protect you against inflation but will not give you the significantly higher returns that stocks offer over time.
We’ve come a long way in sixteen chapters. Yes, it is a very different investment world out there today, and it is likely to continue to be difficult for some years to come. But it is not a world without major opportunities. Benjamin Graham used the following epigraph in his book Security Analysis, published in 1934, near the bottom of the Great Depression: “Many shall be restored that now are fallen, and many shall fall that are now in honor” (Horace, Ars Poetica, 18 B.C.).20 And so it has always been and will be again.
We have come through a terrifying period, but our system, though banged up, is still intact. And it will recover. The financial damage has been great, but our institutions and our democracy are still very much in place.
Looking back at the Great Depression of the 1930s, now almost eighty years ago, we see a period when the social fabric of the country was severely torn. The U.S. system was sharply criticized by anarchists, Communists, and large numbers of average people, including many thousands of World War I soldiers, who, after having given their all, marched on Washington in 1932 because they believed the country had abandoned them in their destitution. Joseph Kennedy, fearing the dangerous mood at the time and fearing major change in our system, allegedly said he would give up half his wealth in order to be assured his family could enjoy the other half in peace and safety.21 We are in difficult times today, but we have faced far worse throughout our history.
The tools that we have discussed in this book, almost all based on modern psychology, have worked and, unless human nature changes, should continue to work well in the years ahead. Remember, too, that this is a whole new set of tools that have not been tried by many, partly because of a lack of knowledge of their existence, partly because they have been frowned on by the prevailing academic theory, but mostly because they are psychological. It is hard to stay independent of the acknowledged best thinking of the day, even harder to avoid the strong tug of Affect, neuropsychology, overconfidence, and the plethora of other similar forces that will push at you to go the other way. These forces get to us all at one time or another. As much as I’ve studied them, they still creep up on me more than I’d like to think.
But if we can know them for what they are, we can not only escape the major damage they can inflict but also harness it. That’s the implicit goal of the strategies in this book and the likely result based on all the evidence, research, analysis, investing experience, and sheer hours of sweating the day-to-day technicalities of this new path in markets. Solid contrarian investments, soundly selected and managed, could put us all well ahead.
Good luck to those of you who are willing to try the new psychological way. And good fortune.