David Foster Wallace – This is Water From Farnam Street


David Foster Wallace: This is Water … or The Truth With A Whole Lot Of Rhetorical Bullshit Pared Away

April 28, 2012 by Shane Parrish


This is one of the best things I’ve ever read — right up there with Hunter Thompson on finding your purpose and living a meaningful life. When you need perspective, This is Water, the commencement speech given by David Foster Wallace to the 2005 graduating class at Kenyon College is the place to start. It proved so popular it was turned into the book This is Water.

This is Water by David Foster Wallace

“Greetings parents and congratulations to Kenyon’s graduating class of 2005. There are these two young fish swimming along and they happen to meet an older fish swimming the other way, who nods at them and says “Morning, boys. How’s the water?” And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes “What the hell is water?”

This is a standard requirement of US commencement speeches, the deployment of didactic little parable-ish stories. The story thing turns out to be one of the better, less bullshitty conventions of the genre, but if you’re worried that I plan to present myself here as the wise, older fish explaining what water is to you younger fish, please don’t be. I am not the wise old fish. The point of the fish story is merely that the most obvious, important realities are often the ones that are hardest to see and talk about. Stated as an English sentence, of course, this is just a banal platitude, but the fact is that in the day to day trenches of adult existence, banal platitudes can have a life or death importance, or so I wish to suggest to you on this dry and lovely morning.

Of course the main requirement of speeches like this is that I’m supposed to talk about your liberal arts education’s meaning, to try to explain why the degree you are about to receive has actual human value instead of just a material payoff. So let’s talk about the single most pervasive cliché in the commencement speech genre, which is that a liberal arts education is not so much about filling you up with knowledge as it is about “teaching you how to think.” If you’re like me as a student, you’ve never liked hearing this, and you tend to feel a bit insulted by the claim that you needed anybody to teach you how to think, since the fact that you even got admitted to a college this good seems like proof that you already know how to think. But I’m going to posit to you that the liberal arts cliché turns out not to be insulting at all, because the really significant education in thinking that we’re supposed to get in a place like this isn’t really about the capacity to think, but rather about the choice of what to think about. If your total freedom of choice regarding what to think about seems too obvious to waste time discussing, I’d ask you to think about fish and water, and to bracket for just a few minutes your scepticism about the value of the totally obvious.

Here’s another didactic little story. There are these two guys sitting together in a bar in the remote Alaskan wilderness. One of the guys is religious, the other is an atheist, and the two are arguing about the existence of God with that special intensity that comes after about the fourth beer. And the atheist says: “Look, it’s not like I don’t have actual reasons for not believing in God. It’s not like I haven’t ever experimented with the whole God and prayer thing. Just last month I got caught away from the camp in that terrible blizzard, and I was totally lost and I couldn’t see a thing, and it was 50 below, and so I tried it: I fell to my knees in the snow and cried out ‘Oh, God, if there is a God, I’m lost in this blizzard, and I’m gonna die if you don’t help me.’” And now, in the bar, the religious guy looks at the atheist all puzzled. “Well then you must believe now,” he says, “After all, here you are, alive.” The atheist just rolls his eyes. “No, man, all that was was a couple Eskimos happened to come wandering by and showed me the way back to camp.”

It’s easy to run this story through kind of a standard liberal arts analysis: the exact same experience can mean two totally different things to two different people, given those people’s two different belief templates and two different ways of constructing meaning from experience. Because we prize tolerance and diversity of belief, nowhere in our liberal arts analysis do we want to claim that one guy’s interpretation is true and the other guy’s is false or bad. Which is fine, except we also never end up talking about just where these individual templates and beliefs come from. Meaning, where they come from INSIDE the two guys. As if a person’s most basic orientation toward the world, and the meaning of his experience were somehow just hard-wired, like height or shoe-size; or automatically absorbed from the culture, like language. As if how we construct meaning were not actually a matter of personal, intentional choice. Plus, there’s the whole matter of arrogance. The nonreligious guy is so totally certain in his dismissal of the possibility that the passing Eskimos had anything to do with his prayer for help. True, there are plenty of religious people who seem arrogant and certain of their own interpretations, too. They’re probably even more repulsive than atheists, at least to most of us. But religious dogmatists’ problem is exactly the same as the story’s unbeliever: blind certainty, a close-mindedness that amounts to an imprisonment so total that the prisoner doesn’t even know he’s locked up.

The point here is that I think this is one part of what teaching me how to think is really supposed to mean. To be just a little less arrogant. To have just a little critical awareness about myself and my certainties. Because a huge percentage of the stuff that I tend to be automatically certain of is, it turns out, totally wrong and deluded. I have learned this the hard way, as I predict you graduates will, too.

Here is just one example of the total wrongness of something I tend to be automatically sure of: everything in my own immediate experience supports my deep belief that I am the absolute centre of the universe; the realest, most vivid and important person in existence. We rarely think about this sort of natural, basic self-centredness because it’s so socially repulsive. But it’s pretty much the same for all of us. It is our default setting, hard-wired into our boards at birth. Think about it: there is no experience you have had that you are not the absolute centre of. The world as you experience it is there in front of YOU or behind YOU, to the left or right of YOU, on YOUR TV or YOUR monitor. And so on. Other people’s thoughts and feelings have to be communicated to you somehow, but your own are so immediate, urgent, real.

Please don’t worry that I’m getting ready to lecture you about compassion or other-directedness or all the so-called virtues. This is not a matter of virtue. It’s a matter of my choosing to do the work of somehow altering or getting free of my natural, hard-wired default setting which is to be deeply and literally self-centered and to see and interpret everything through this lens of self. People who can adjust their natural default setting this way are often described as being “well-adjusted”, which I suggest to you is not an accidental term.

Given the triumphant academic setting here, an obvious question is how much of this work of adjusting our default setting involves actual knowledge or intellect. This question gets very tricky. Probably the most dangerous thing about an academic education–least in my own case–is that it enables my tendency to over-intellectualise stuff, to get lost in abstract argument inside my head, instead of simply paying attention to what is going on right in front of me, paying attention to what is going on inside me.

As I’m sure you guys know by now, it is extremely difficult to stay alert and attentive, instead of getting hypnotised by the constant monologue inside your own head (may be happening right now). Twenty years after my own graduation, I have come gradually to understand that the liberal arts cliché about teaching you how to think is actually shorthand for a much deeper, more serious idea: learning how to think really means learning how to exercise some control over how and what you think. It means being conscious and aware enough to choose what you pay attention to and to choose how you construct meaning from experience. Because if you cannot exercise this kind of choice in adult life, you will be totally hosed. Think of the old cliché about “the mind being an excellent servant but a terrible master.”

This, like many clichés, so lame and unexciting on the surface, actually expresses a great and terrible truth. It is not the least bit coincidental that adults who commit suicide with firearms almost always shoot themselves in: the head. They shoot the terrible master. And the truth is that most of these suicides are actually dead long before they pull the trigger.

And I submit that this is what the real, no bullshit value of your liberal arts education is supposed to be about: how to keep from going through your comfortable, prosperous, respectable adult life dead, unconscious, a slave to your head and to your natural default setting of being uniquely, completely, imperially alone day in and day out. That may sound like hyperbole, or abstract nonsense. Let’s get concrete. The plain fact is that you graduating seniors do not yet have any clue what “day in day out” really means. There happen to be whole, large parts of adult American life that nobody talks about in commencement speeches. One such part involves boredom, routine and petty frustration. The parents and older folks here will know all too well what I’m talking about.

By way of example, let’s say it’s an average adult day, and you get up in the morning, go to your challenging, white-collar, college-graduate job, and you work hard for eight or ten hours, and at the end of the day you’re tired and somewhat stressed and all you want is to go home and have a good supper and maybe unwind for an hour, and then hit the sack early because, of course, you have to get up the next day and do it all again. But then you remember there’s no food at home. You haven’t had time to shop this week because of your challenging job, and so now after work you have to get in your car and drive to the supermarket. It’s the end of the work day and the traffic is apt to be: very bad. So getting to the store takes way longer than it should, and when you finally get there, the supermarket is very crowded, because of course it’s the time of day when all the other people with jobs also try to squeeze in some grocery shopping. And the store is hideously lit and infused with soul-killing muzak or corporate pop and it’s pretty much the last place you want to be but you can’t just get in and quickly out; you have to wander all over the huge, over-lit store’s confusing aisles to find the stuff you want and you have to manoeuvre your junky cart through all these other tired, hurried people with carts (et cetera, et cetera, cutting stuff out because this is a long ceremony) and eventually you get all your supper supplies, except now it turns out there aren’t enough check-out lanes open even though it’s the end-of-the-day rush. So the checkout line is incredibly long, which is stupid and infuriating. But you can’t take your frustration out on the frantic lady working the register, who is overworked at a job whose daily tedium and meaninglessness surpasses the imagination of any of us here at a prestigious college.

But anyway, you finally get to the checkout line’s front, and you pay for your food, and you get told to “Have a nice day” in a voice that is the absolute voice of death. Then you have to take your creepy, flimsy, plastic bags of groceries in your cart with the one crazy wheel that pulls maddeningly to the left, all the way out through the crowded, bumpy, littery parking lot, and then you have to drive all the way home through slow, heavy, SUV-intensive, rush-hour traffic, et cetera et cetera.

Everyone here has done this, of course. But it hasn’t yet been part of you graduates’ actual life routine, day after week after month after year.

But it will be. And many more dreary, annoying, seemingly meaningless routines besides. But that is not the point. The point is that petty, frustrating crap like this is exactly where the work of choosing is gonna come in. Because the traffic jams and crowded aisles and long checkout lines give me time to think, and if I don’t make a conscious decision about how to think and what to pay attention to, I’m gonna be pissed and miserable every time I have to shop. Because my natural default setting is the certainty that situations like this are really all about me. About MY hungriness and MY fatigue and MY desire to just get home, and it’s going to seem for all the world like everybody else is just in my way. And who are all these people in my way? And look at how repulsive most of them are, and how stupid and cow-like and dead-eyed and nonhuman they seem in the checkout line, or at how annoying and rude it is that people are talking loudly on cell phones in the middle of the line. And look at how deeply and personally unfair this is.

Or, of course, if I’m in a more socially conscious liberal arts form of my default setting, I can spend time in the end-of-the-day traffic being disgusted about all the huge, stupid, lane-blocking SUV’s and Hummers and V-12 pickup trucks, burning their wasteful, selfish, 40-gallon tanks of gas, and I can dwell on the fact that the patriotic or religious bumper-stickers always seem to be on the biggest, most disgustingly selfish vehicles, driven by the ugliest [responding here to loud applause] — this is an example of how NOT to think, though — most disgustingly selfish vehicles, driven by the ugliest, most inconsiderate and aggressive drivers. And I can think about how our children’s children will despise us for wasting all the future’s fuel, and probably screwing up the climate, and how spoiled and stupid and selfish and disgusting we all are, and how modern consumer society just sucks, and so forth and so on.

You get the idea.

If I choose to think this way in a store and on the freeway, fine. Lots of us do. Except thinking this way tends to be so easy and automatic that it doesn’t have to be a choice. It is my natural default setting. It’s the automatic way that I experience the boring, frustrating, crowded parts of adult life when I’m operating on the automatic, unconscious belief that I am the centre of the world, and that my immediate needs and feelings are what should determine the world’s priorities.

The thing is that, of course, there are totally different ways to think about these kinds of situations. In this traffic, all these vehicles stopped and idling in my way, it’s not impossible that some of these people in SUV’s have been in horrible auto accidents in the past, and now find driving so terrifying that their therapist has all but ordered them to get a huge, heavy SUV so they can feel safe enough to drive. Or that the Hummer that just cut me off is maybe being driven by a father whose little child is hurt or sick in the seat next to him, and he’s trying to get this kid to the hospital, and he’s in a bigger, more legitimate hurry than I am: it is actually I who am in HIS way.

Or I can choose to force myself to consider the likelihood that everyone else in the supermarket’s checkout line is just as bored and frustrated as I am, and that some of these people probably have harder, more tedious and painful lives than I do.

Again, please don’t think that I’m giving you moral advice, or that I’m saying you are supposed to think this way, or that anyone expects you to just automatically do it. Because it’s hard. It takes will and effort, and if you are like me, some days you won’t be able to do it, or you just flat out won’t want to.

But most days, if you’re aware enough to give yourself a choice, you can choose to look differently at this fat, dead-eyed, over-made-up lady who just screamed at her kid in the checkout line. Maybe she’s not usually like this. Maybe she’s been up three straight nights holding the hand of a husband who is dying of bone cancer. Or maybe this very lady is the low-wage clerk at the motor vehicle department, who just yesterday helped your spouse resolve a horrific, infuriating, red-tape problem through some small act of bureaucratic kindness. Of course, none of this is likely, but it’s also not impossible. It just depends what you want to consider. If you’re automatically sure that you know what reality is, and you are operating on your default setting, then you, like me, probably won’t consider possibilities that aren’t annoying and miserable. But if you really learn how to pay attention, then you will know there are other options. It will actually be within your power to experience a crowded, hot, slow, consumer-hell type situation as not only meaningful, but sacred, on fire with the same force that made the stars: love, fellowship, the mystical oneness of all things deep down.

Not that that mystical stuff is necessarily true. The only thing that’s capital-T True is that you get to decide how you’re gonna try to see it.

This, I submit, is the freedom of a real education, of learning how to be well-adjusted. You get to consciously decide what has meaning and what doesn’t. You get to decide what to worship.

Because here’s something else that’s weird but true: in the day-to-day trenches of adult life, there is actually no such thing as atheism. There is no such thing as not worshipping. Everybody worships. The only choice we get is what to worship. And the compelling reason for maybe choosing some sort of god or spiritual-type thing to worship–be it JC or Allah, be it YHWH or the Wiccan Mother Goddess, or the Four Noble Truths, or some inviolable set of ethical principles–is that pretty much anything else you worship will eat you alive. If you worship money and things, if they are where you tap real meaning in life, then you will never have enough, never feel you have enough. It’s the truth. Worship your body and beauty and sexual allure and you will always feel ugly. And when time and age start showing, you will die a million deaths before they finally grieve you. On one level, we all know this stuff already. It’s been codified as myths, proverbs, clichés, epigrams, parables; the skeleton of every great story. The whole trick is keeping the truth up front in daily consciousness.

Worship power, you will end up feeling weak and afraid, and you will need ever more power over others to numb you to your own fear. Worship your intellect, being seen as smart, you will end up feeling stupid, a fraud, always on the verge of being found out. But the insidious thing about these forms of worship is not that they’re evil or sinful, it’s that they’re unconscious. They are default settings.

They’re the kind of worship you just gradually slip into, day after day, getting more and more selective about what you see and how you measure value without ever being fully aware that that’s what you’re doing.

And the so-called real world will not discourage you from operating on your default settings, because the so-called real world of men and money and power hums merrily along in a pool of fear and anger and frustration and craving and worship of self. Our own present culture has harnessed these forces in ways that have yielded extraordinary wealth and comfort and personal freedom. The freedom all to be lords of our tiny skull-sized kingdoms, alone at the centre of all creation. This kind of freedom has much to recommend it. But of course there are all different kinds of freedom, and the kind that is most precious you will not hear much talk about much in the great outside world of wanting and achieving…. The really important kind of freedom involves attention and awareness and discipline, and being able truly to care about other people and to sacrifice for them over and over in myriad petty, unsexy ways every day.

That is real freedom. That is being educated, and understanding how to think. The alternative is unconsciousness, the default setting, the rat race, the constant gnawing sense of having had, and lost, some infinite thing.

I know that this stuff probably doesn’t sound fun and breezy or grandly inspirational the way a commencement speech is supposed to sound. What it is, as far as I can see, is the capital-T Truth, with a whole lot of rhetorical niceties stripped away. You are, of course, free to think of it whatever you wish. But please don’t just dismiss it as just some finger-wagging Dr Laura sermon. None of this stuff is really about morality or religion or dogma or big fancy questions of life after death.

The capital-T Truth is about life BEFORE death.

It is about the real value of a real education, which has almost nothing to do with knowledge, and everything to do with simple awareness; awareness of what is so real and essential, so hidden in plain sight all around us, all the time, that we have to keep reminding ourselves over and over:

“This is water.”

“This is water.”

It is unimaginably hard to do this, to stay conscious and alive in the adult world day in and day out. Which means yet another grand cliché turns out to be true: your education really IS the job of a lifetime. And it commences: now.

I wish you way more than luck.

* * * *

This is Water, which makes a great gift.


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Atlantic: Stop Calling Marriage a ‘Luxury Good’


Stop Calling Marriage a ‘Luxury Good’

If you want to talk about economic inequality in matrimony, don’t just look at the weddings. Look at the divorces.

For college graduates, marriage is a promise you make late—and tend to keep. For non-college-graduates, it’s a promise you make early—and tend to break.

That is the very simplest I can break down this massive, and massively interesting, survey from the Bureau of Labor Statistics, on marriage trends by education and race. There have been a lot of articles this year comparing marriage to a “luxury good”—something the rich do and the poor avoid. It’s not that simple.

Let’s begin with a graph (of course) that illustrates the first paragraph of this article, perfectly. You’re looking at marriages rates for Americans born around 1960, surveyed by the National Longitudinal Survey of Youth 1979, up until 2010. Focus on the the crossing lines. College-educated men and women marry later—age 26.5 versus 22.7 for non-grads—but marry a little more frequently, and divorce much less.

So why is it misleading to call marriage a “luxury good”? A luxury good is something the rich buy, and the poor don’t. But the majority of practically every major demographic gets married before their 40s. That’s not a luxury good. That’s just … a good.

If marriage were truly a luxury good, you’d expect marriage rates to be wildly different by education attainment, since education levels strongly predict income. But they don’t. At all levels of education attainment (which I’m using as a rough proxy for income), marriage is pretty common. This is not what a luxury good looks like …

But there are two inequality stories when it comes to marriage. The first is race. The second is divorce.

Even though there is no marriage gap by education, there is a huge marriage gap between blacks and the rest of the population surveyed by BLS. Blacks marry later (and less often) than whites or Hispanics, as the graph below shows clearly.

In fact, blacks are three-times more likely to be unmarried by the age of 46 than the rest of the population. If they divorce, they are also less likely to get married again. (The fact that the market for marriage is hugely different by race, but not by education attainment, is fascinating to me, but I don’t have a clear explanation for it now.)

The second inequality story is about divorce. Divorce doesn’t look like a luxury good; it looks like an inferior good. The richer you are, the less likely you are to do it. Divorce rates by age 46 are twice as high among high-school dropouts than college grads.

The point isn’t that a 30-percent divorce rate among bachelor’s degree holders is low. Divorce is common. But it’s much, much more common for drop-outs and graduates of high school, only.

This same point is made more starkly (albeit less colorfully) in new study of divorce trends from Demographic Research. Watch the rising black bars and falling white bars. The story you’re following is that divorce rates among dropouts are going up, up, up, while divorce for bachelor’s holders have fallen to half-century lows. Today, more than half of the marriages by men and women with less than a high school diploma end in divorce, according to BLS.

Marriage sorta-kinda looks like a luxury good. But divorce definitely looks like the opposite: an inferior good, with rising demand among the lowest-educated (and lowest earners) and falling demand among the rich. 

Let’s throw one more variable into the mix: Age. Younger marriages are more likely to end in divorce, no matter how long you spend at school. Among marriages beginning between 15 and 22, nearly 60 percent ended in divorce (including nearly 50 percent among college-educated couples). “People who marry later are more likely than younger couples to stay married,” the researchers found.


That’s a lot of marriage data in one bite, but this isn’t just matrimony trivia. Too many single-parent households, which cluster among the least-educated, are a blight on both adult lives and child development. The children of rich, college educated parents aren’t just lucky because their parents are rich and college-educated. They’re lucky because they have parents, plural, in the household, who can divide work and child-care. “Young people from less-privileged homes are more likely to graduate from college and earn more if raised by two married parents,” Brad Wilcox wrote for The Atlantic just yesterday. Marriage rates aren’t just pushed around by larger economic forces. They push back.

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Atlantic: Your Brain on Poverty: Why Poor People Seem to Make Bad Decisions


Your Brain on Poverty: Why Poor People Seem to Make Bad Decisions

And why their “bad” decisions might be more rational than you’d think.

In August, Science published a landmark study concluding that poverty, itself, hurts our ability to make decisions about school, finances, and life, imposing a mental burden similar to losing 13 IQ points. 

It was widely seen as a counter-argument to claims that poor people are “to blame” for bad decisions and a rebuke to policies that withhold money from the poorest families unless they behave in a certain way. After all, if being poor leads to bad decision-making (as opposed to the other way around), then giving cash should alleviate the cognitive burdens of poverty, all on its own.

Sometimes, science doesn’t stick without a proper anecdote, and “Why I Make Terrible Decisions,” a comment published on Gawker‘s Kinja platform by a person in poverty, is a devastating illustration of the Science study. I’ve bolded what I found the most moving, insightful portions, but it’s a moving and insightful testimony all the way through.

I make a lot of poor financial decisions. None of them matter, in the long term. I will never not be poor, so what does it matter if I don’t pay a thing and a half this week instead of just one thing? It’s not like the sacrifice will result in improved circumstances; the thing holding me back isn’t that I blow five bucks at Wendy’s. It’s that now that I have proven that I am a Poor Person that is all that I am or ever will be. It is not worth it to me to live a bleak life devoid of small pleasures so that one day I can make a single large purchase. I will never have large pleasures to hold on to. There’s a certain pull to live what bits of life you can while there’s money in your pocket, because no matter how responsible you are you will be broke in three days anyway. When you never have enough money it ceases to have meaning. I imagine having a lot of it is the same thing.

Poverty is bleak and cuts off your long-term brain. It’s why you see people with four different babydaddies instead of one. You grab a bit of connection wherever you can to survive. You have no idea how strong the pull to feel worthwhile is. It’s more basic than food. You go to these people who make you feel lovely for an hour that one time, and that’s all you get. You’re probably not compatible with them for anything long-term, but right this minute they can make you feel powerful and valuable. It does not matter what will happen in a month. Whatever happens in a month is probably going to be just about as indifferent as whatever happened today or last week. None of it matters. We don’t plan long-term because if we do we’ll just get our hearts broken. It’s best not to hope. You just take what you can get as you spot it.

When neuroscientists Joseph W. Kable and Joseph T. McGuire studied time, uncertainty and decision-making, they found that virtues like patience and self-control weren’t as simple previous studies suggested. In the ubiquitous Marshmallow study, for example, kids who ate the treat quickly were deemed impatient and kids who waited had self-control and, on the whole, went on to lead more productive lives, the study found.

But rational self-control in the real world, Kable says, isn’t so black-and-white. Perhaps you have enough patience to wait an hour for a train, or to lose one pound each week with exercise and dieting. That sounds responsible. But what happens if the train isn’t there in 90 minutes? If you never lose weight and you’re making yourself miserable with your diet? Maybe you should give up! “In this situation, giving up can be a natural — indeed, a rational — response to a time frame that wasn’t properly framed to begin with,” Maria Konnikova summed it up for the Times.

As Andrew Golis points out, this might suggest something even deeper than the idea that poverty’s stress interferes with our ability to make good decisions. The inescapability of poverty weighs so heavily on the author that s/he abandons long-term planning entirely, because the short term needs are so great and the long-term gains so implausible. The train is just not coming. What if the psychology of poverty, which can appear so irrational to those not in poverty, is actually “the most rational response to a world of chaos and unpredictable outcomes,” he wrote.

None of this is an argument against poorer families trying to save or plan for the long-term. It’s an argument for context. As Eldar Shafir, the author of the Science study, told The Atlantic Cities‘ Emily Badger: “All the data shows it isn’t about poor people, it’s about people who happen to be in poverty. All the data suggests it is not the person, it’s the context they’re inhabiting.”

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VoxEU: Do trans-fat bans save lives?


Do trans-fat bans save lives?

Brandon Restrepo, Matthias Rieger, 16 July 2014

The use of artificial trans fat or partially hydrogenated oil – which is industrially produced by adding hydrogen gas to liquid vegetable oil – is widespread across the world’s food production chains and service industries. Aside from the fact that it has the same caloric value as any other fat, there are no known health benefits to consuming artificial trans fat. The food industry prefers using trans-fat-containing oils to healthier oils because it is cheap, it increases the shelf life of food products, it promotes flavour stability, and it improves the texture of food. Artificial trans fat is typically found in shortenings, margarines, fried fast foods, baked goods, and snack foods (Eckel et al. 2007).

But how much do we really know about artificial trans fat? Well, we know that eating foods containing artificial trans fat increases the risk of developing cardiovascular diseases (CVDs) such as heart disease and stroke, because it raises bad cholesterol and lowers good cholesterol (Mozaffarian et al. 2006). Thus artificial trans fat is worse than saturated fat, which increases both good and bad cholesterol. The American Medical Association has recently supported the Food and Drug Administration’s recommendation to eliminate artificial trans fat from the US food supply (AMA 2013). Some European countries (e.g. Denmark and Switzerland) have also recently made efforts to eliminate artificial trans fat from their food supply.

What we do not know, however, is how much of an effect banning artificial trans fat will have on public health.

The impact of banning artificial trans fat on cardiovascular health: First causal evidence

In a recent paper (Restrepo and Rieger 2014), we exploit the fact that New York City and six other county health departments implemented trans fat bans in all food service establishments that require a permit to serve food between 2007 and 2011. This allows us to assess whether artificial trans fat consumption has a causal impact on cardiovascular health and CVD mortality rates.

Using variation in the artificial trans fat content in the local food supply of a total of 11 New York State counties resulting from the policy mandate, we find that trans fat bans caused a 4% reduction in deaths attributable to CVD. We also find evidence that the reduction in mortality caused by trans fat bans is mostly driven by individuals who are at the greatest risk of dying from CVD, namely, senior citizens.

How were CVD mortality rates trending before trans fat bans were implemented?

A natural question that arises is: Did the CVD mortality trends in counties that implemented trans fat bans differ from those in counties that never implemented them? If the trends before the bans were similar, then the counties that did not implement the bans may be viewed as a suitable ‘control group’, and as a good counterfactual for the CVD mortality trajectory that the ‘treatment group’ would have followed in the absence of trans fat bans.

We address this issue by normalising each treatment county’s trans-fat-ban implementation year to zero and plotting CVD mortality rates by treatment status. Figure 1 shows that the CVD mortality rates in ‘treatment’ and ‘control’ counties were trending in a very similar fashion before trans fat bans were implemented by ‘treatment’ counties. A clear downward break from trend is observed in the implementation year for ‘treatment’ counties, whereas the trend in ‘control’ counties appears to follow its pre-implementation-period trajectory.

Figure 1. Trends of cardiovascular-disease-related mortality per 100,000 persons by treatment status


Notes: Authors’ calculations based on Vital Statistics of New York State. These are mean CVD mortality rates by county and year. We assume that a ban is in effect if the law has been effective for at least six months in a given year. Each county’s implementation year is normalised to zero.

This figure alone suggests that trans fat bans were effective in reducing CVD mortality rates. However, we conduct a regression analysis to account for the fact that ‘treatment’ counties are seemingly ‘healthier’ (as measured by lower CVD mortality rates throughout the study period) and to rule out the possibility that the relationship between trans fat bans and CVD mortality rates is merely a spurious correlation.

How many lives have trans fat bans saved?

Figure 2 shows Ordinary Least Squares (OLS) estimates of the reduction in overall CVD mortality rates, heart disease mortality rates, and stroke mortality rates caused by trans fat bans, along with their corresponding 95% confidence interval bands. We find that trans fat bans reduce CVD deaths by 12 per 100,000 persons, reduce heart disease deaths by 9.5 per 100,000 persons, and reduce stroke deaths by 2.6 per 100,000 persons. (These are estimated reductions of about 4.4%, 3.9%, and 8.5% relative to our sample means.) The estimated reduction in CVD is economically important – for instance, it is about twice the size of the mortality rate per 100,000 persons for cirrhosis of the liver in New York State in 2006.

Figure 2. Trans fat bans and cardiovascular disease mortality by type of disease


Notes: Authors’ calculations based on Vital Statistics of New York State. These estimates are based on regressions of (log) CVD, heart disease, and stroke mortality rates on the following independent variables: treatment dummy (1 if a county implemented a trans fat ban, 0 otherwise), county level unemployment rate and (log) personal income per capita, and a dummy for New York City interacted with a dummy for years 2010–2012 to account for hospital-level interventions aimed at improving the accuracy of cause-of-death reporting. N = 682, standard errors are always clustered at the county level.

To get a better sense of the magnitude of our estimates, consider the following back-of-the envelope calculation. New York State counties that implemented trans fat bans over our study period had 34,215 heart-disease-related deaths in 2006, so our estimates indicate that, on average, implementation of trans fat bans prevented about 1,300 (3.9% × 34,215) heart-disease-related deaths per year. Assuming a discount rate of 3%, Aldy and Viscusi (2008) find that the cohort-adjusted Value of a Statistical Life-Year is about $302,000. Even if fatal heart attacks cause only one year of life to be lost, the fatal heart attacks prevented by trans fat bans can be valued at about $393 million annually.

Figure 3 shows OLS estimates of the reduction in all-cause mortality rates caused by trans fat bans by age group, along with their corresponding 95% confidence interval bands. We find that the estimated effects of trans fat bans on total mortality rates are small in magnitude for non-seniors, and we can never reject the null hypothesis that these estimates are statistically equal to zero. In contrast, we find that trans fat bans have a large negative effect on the all-cause mortality rates of senior citizens, which we estimate to be a reduction of about 15 per 100,000 persons. Note that this estimate is very similar in size to the estimated reduction in CVD mortality rates we presented in Figure 2. This suggests that most of the impact of trans fat bans on total mortality is driven by its impact on CVD mortality.

Figure 3. Trans fat bans and total mortality by age group


Notes: Authors’ calculations based on Vital Statistics of New York State. These estimates are based on regressions of (log) CVD, heart disease, and stroke mortality rates on the following independent variables: treatment dummy (1 if a county implemented a trans fat ban, 0 otherwise), county level unemployment rate and (log) personal income per capita, and a dummy for New York City interacted with a dummy for years 2010–2012 to account for hospital-level interventions aimed at improving the accuracy of cause-of-death reporting. N = 682, standard errors are always clustered at the county level.


Our analysis reveals that trans fat bans are effective in reducing deaths attributed to CVD such as heart disease and stroke. European countries such as Denmark and Switzerland, as well as many local and state jurisdictions outside of New York State, have also passed laws restricting the amount of artificial trans fat that food production and service industries are allowed to use. In 2013, the Food and Drug Administration made a preliminary determination to remove artificial trans fat from its Generally Regarded as Safe database, which is likely to eliminate it from the US food supply in the coming years.

Heart disease is the leading cause of death in New York State and in the US, and stroke is not far behind. In the US, the total cost of the major types of CVD was estimated to be about $444 billion in 2010, and treatment of these diseases accounts for nearly 17 cents of every dollar that is spent on health care (Centers for Disease Control and Prevention 2011). The New York experience can prove valuable for many public health authorities around the globe. Eliminating artificial trans fat – which has no known health benefits – from the global food supply has the potential to lead to substantial reductions in the loss of life and health care costs associated with CVD.


Aldy, J E and W K Viscus (2008), “Adjusting the Value of a Statistical Life for Age and Cohort Effects”, Review of Economics and Statistics, 90(3): 573–581.

American Medical Association (2013), “AMA: Trans Fat Ban Would Save Lives”, 7 November. 

Centers for Disease Control and Prevention (2011), “Heart Disease and Stroke Prevention – Addressing the Nation’s Leading Killers: At a Glance 2011”.

Eckel R, S Borra, A Lichtenstein, and S Yin-Piazza (2007), “Understanding the Complexity of Trans Fatty Acid Reduction in the American Diet”, Circulation, 115: 2231–2246.

Mozaffarian D, M B Katan, A Ascherio, M J Stampfer, and W C Willett (2006), “Trans Fatty Acids and Cardiovascular Disease”, New England Journal of Medicine, 354: 1601–1613.

Restrepo, B and M Rieger (2014), “Trans Fat and Cardiovascular Disease Mortality: Evidence from Bans in Restaurants in New York”, European University Institute Max Weber Programme Working Paper 2014/12. 

Topics: Health economics
Tags: cardiovascular disease, diet, food, health, New York, restaurants, trans fat

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Philosophical Economics: Fixing the Shiller CAPE: Accounting, Dividends, and the Permanently High Plateau


Fixing the Shiller CAPE: Accounting, Dividends, and the Permanently High Plateau
Posted on December 13, 2013 by jesse_livermore


For most of history, the Shiller Cyclically-Adjusted Price-Earnings ratio (CAPE) oscillated in a pseudo sine wave around a long-term (130 year) average of 15.30. It spent 55% percent of the time above the average, and 45% of the time below–a reasonable result for a metric that allegedly mean reverts. Since 1990, however, the metric has only spent 2% of the time below its historical average–98% of the time above.

The metric’s failure to mean-revert over the last 23 years hasn’t been for a lack of reasons. The period covered three recessions, two stock market crashes, and one bonafide financial panic–the likes of which hadn’t been seen since the Great Depression. Even in the worst parts of the 2008-2009 crash–at levels that we now look back on with nostalgia as the “buying opportunity” of our generation–the metric failed to provide an accurate valuation signal. In an inexcusable blunder, it basically called the market “slightly below fair value” (see the black circle).

If we’re being honest, there are only two possibilities. Either the “normal” levels of the metric have shifted significantly upwards over the last few decades, or the metric is broken. There is no other way to coherently explain why the metric has consistently failed to migrate towards its long-term average, or spend any amount of time below it, as it should do every so often in bear markets.

Which possibility is it? In my view, both. The Shiller CAPE, as constructed by its proponents, utilizes inconsistent data. In this piece, I’m going to explain the inconsistency in rigorous accounting detail, and then share the results of a modified version of CAPE that eliminates it. I’m also going to illustrate the distortion that changes in dividend payout ratios create for CAPE. Finally, I’m going to taunt the bears (slightly facetiously) and argue that valuations have probably reached a “permanently high plateau”, to borrow the famously fatal words of Irving Fisher in October 1929.

There is no question that the current stock market is more expensive than the averages of certain past eras–the 1910s, 1930s, 1940s, 1970s, 1980s, etc. Looking forward, long-term equity returns will obviously be lower than they were in those eras. But the market is not as expensive as the Shiller CAPE suggests. Moreover, there’s no reason to think that the valuations of those eras–distorted by world wars (1914-1918, 1939-1945, 1950-1953), gross economic mismanagement (1929-1938), and painfully high inflation and interest rates (1970-1982)–were somehow more “appropriate” than current valuations. The valuations in those eras were “appropriate” to the circumstances of those eras; we live in different circumstances.

The Use of Reported Earnings: Inconsistently Measured Data

(Please note that the points below–related to accounting inconsistencies and dividend payout ratio distortions in the Shiller CAPE–are not new. Jeremy Siegel, legendary professor at the Wharton School of Business, has been raising them publicly since at least 2008.)

The Shiller CAPE was developed by Nobel Laureate Robert Shiller, the well-known originator of the Case-Shiller house price index. The metric is calculated by dividing an index’s inflation-adjusted price by the average of its inflation-adjusted annual earnings over the last 10 years.

But how does one define “earnings”? As far as the metric is concerned, the answer doesn’t matter, as long as the definition is consistent across time. If the definition is consistent across time, then apples-to-apples comparisons can be made between the metric’s present value and its prior values. The comparisons will give an accurate indication of how cheap or expensive the index is relative to its history, or to what is “normal” for it.

Unfortunately, the earnings data on Dr. Shiller’s website, which are used to build the Shiller CAPE, are not based on a consistent definition of “earnings” across time. The data are taken from S&P “reported” earnings, which are formulated in accordance with Generally Accepted Accounting Principles (GAAP). But the standards of GAAP have changed significantly over the last few decades.

One of the most important changes involves how “goodwill” is accounted. Conceptually, a company’s earnings can be thought of as the change in its book value before dividends are paid. When one company buys another, the purchase price is almost always higher than book value–usually multiples higher. But if the buyer pays a higher price for the company than its book value, then his own book value is going to fall in the acquisition. He’ll be parting with more cash than he’ll be receiving in net assets from the company that he’s taking in. To avoid the creation of an illusory loss, he is allowed under GAAP to add the difference between the payment price and the book value to his balance sheet as an intangible asset–called “goodwill.” This addition keeps his own book value constant, and prevents him from having to report an accounting loss.

In the old days, GAAP required goodwill amounts to be amortized–deducted from earnings as an incremental non-cash expense–over a forty year period. But in 2001, the standard changed. FAS 142 was introduced, which eliminated the amortization of goodwill entirely. Instead of amortizing the goodwill on their balance sheets over a multi-decade period, companies are now required to annually test it for impairment. In plain english, this means that they have to examine, on an annual basis, any corporate assets that they’ve acquired, and make sure that those assets are still reasonably worth the prices paid. If they conclude that the assets are not worth the prices paid, then they have to write down their goodwill. The requirement for annual impairment testing doesn’t just apply to goodwill, it applies to all intangible asssets, and, per FAS 144 (issued a couple months later), all long-lived assets.

The biggest disadvantage to FAS 142 is its asymmetry. When a company makes an acquisition that it later realizes was a mistake, as happened with Time Warner in its famous purchase of AOL at the peak of the dot com bubble, the company has to book a loss. In Time Warner’s case, the loss was a record $54B. But when a company makes an acquisition that turns out to be a huge success–for example, Google’s brilliant acquisition of Youtube–the company doesn’t get to book a profit. Youtube is still sitting on Google’s balance sheet today at cost, though it is probably worth 10 times the price paid on a fair value basis.

Now, FAS 142 may be a more accurate accounting standard than its predecessor, but that isn’t the issue for the Shiller CAPE. The issue for the Shiller CAPE is that the accounting standard is not being applied consistently across time. None of the “reported” earnings numbers used in the Shiller CAPE for years before 2001 were held to the harsh standard of FAS 142. But all of the “reported” earnings numbers used in the metric for years after 2001 were held to that standard. Consequently, any comparison between the present value of the metric and pre-2001 values is a comparison between inconsistently measured data points. The present values end up looking more expensive relative to the past than they actually are.

You might think that these accounting changes aren’t a big deal. But they’re a huge deal, especially in the present environment, where the prior 10 year period includes the aftermath of the Tech bubble and the earnings chaos of the Housing Downturn and Great Recession. These periods were littered with painful writedowns. In the fourth quarter of 2008 alone, writedowns were large enough to wipe out almost all of the earnings in the index. If the same standards had been applied during the painful recessions of the mid 1970s and early 1980s, or the M&A binge that followed, reported earnings would have been significantly lower.

We can visually observe the significance of the changes by comparing S&P reported earnings to Pro-Forma (non-GAAP) earnings measures. Bloomberg offers a time series of trailing twelve month earnings for the S&P 500 (T12_EPS_AGGTE) that dates back to 1954. The following chart shows the trajectory of this series alongside reported earnings.


For most of history, the two series closely tracked each other. But since the beginning of the last decade, they’ve significantly deviated, especially in periods around recessions. The biggest reason for the deviation is the introduction of FAS 142, first implemented in 2001, near the break in the chart.

For a better picture of the sharpness of the deviation, the following chart shows the difference between reported earnings and Pro-Forma earnings divided by Pro-Forma earnings.


Some have proposed that we fix the problem by excluding recessionary periods from the metric. This would certainly help remove the penalty that the market faced from 2009 to 2012, when, purely by chance, its prior 10 year period included two big earnings recessions. But it won’t fix the problem of the inconsistent earnings measurement. The deviation that has emerged in reported earnings extends to post-recessionary periods as well.

Now, let me say one more time, I’m not arguing that Pro-Forma earnings are more accurate than reported earnings, or that FAS 142 (or 144) is inaccurate as an accounting standard, or that any other accounting change instituted since the late 1990s is inaccurate. The question is not a question of accuracy–it’s a question of consistency. The reported numbers are not consistent across time, therefore they cannot be used to build a reliable valuation metric.

We can confirm the inconsistency with a second source: profits in the National Income and Product Accounts (NIPA), aggregated by the Bureau of Economic Analysis (BEA) for all U.S. corporations (NIPA Table 1.12, Line 15). For most of history, there has been a reasonable correlation between NIPA profits and reported earnings for the S&P 500. As expected, the correlation has broken down over the last decade. The following table shows the correlations between NIPA Profits, Reported Earnings (GAAP), and Pro-Forma earnings for each completed decade back to 1954.


Notice that the correlation between NIPA and Pro-Forma seen in the decade 2000-2010 is roughly in line with the average correlation seen over the prior 5 decades–72.0% versus an average of 84.3%. In stark contrast, the correlation between NIPA and GAAP seen in the decade 2000-2010 is more than 3 standard deviations off of the average correlation seen over the prior 5 decades–45.0% versus an average of 85.0%. The substantial, isolated deviation between NIPA and GAAP in the decade 2000-2010 is conclusive proof that GAAP standards changed materially during the period.

Fixing the Shiller CAPE

The Shiller CAPE is one of the few metrics that provides a non-cyclical indication of market valuation. Such an indication is particularly useful during recessions, when the market’s true value is hidden by temporary corporate weakness.

There are other non-cyclical metrics that we can use to assess valuation–two examples are price to book (or Q-ratio) and price to sales (or market capitalization divided by GDP). But these metrics carry the disadvantage of being static with respect to profit margins. The Shiller CAPE, in contrast, is dynamic. To illustrate the difference with a relevant example, suppose that an economy sees structural reductions in its corporate tax rates and interest rates that lead to structurally higher profit margins and (deservedly) higher stock prices. Valuation metrics based on price to book and price to sales ignore the bottom line, and therefore cannot detect this change. In the presence of the higher stock prices, these metrics will forever show the market as “overvalued.” The Shiller CAPE, however, takes an average of earnings over time, and therefore will detect the change, especially if it is gradual.

Fortunately, we can fix the inconsistency in the Shiller CAPE by building the metric with the Pro-Forma earnings data set rather than the GAAP earnings data set. The following chart shows the Pro-Forma CAPE alongside the GAAP CAPE, going back to 1954 (to calculate the average earnings in the 10 year period prior to 1954, we used GAAP for both metrics, since the two were very close in that general era):


With the S&P at 1775, the GAAP CAPE is currently at 24.51, a frightening 60% above its historical (130 year) average of 15.30. The Pro-Forma CAPE, in contrast, is currently at 20.63, a more modest 19% above its historical (59 year) average of 17.35. To be fair, the Pro-Forma data doesn’t extend past 1954, and so the Pro-Forma CAPE average doesn’t include the depressed valuations of WW1, the Great Depression, and WW2, as the GAAP CAPE average does. But in terms of accuracy, that’s a good thing. As we’ll see later, the market dynamics of those eras are of little relevance to the present era.

The following chart shows Pro-Forma CAPE relative to its average since 1954.


To get to fair value on Pro-Forma CAPE, we would need a garden-variety correction of 15%, down to around 1500 on the S&P. But to get to fair value on GAAP CAPE, we would need a plunge of 40%, down to around 1100 on the S&P. This difference has crucial implications for tactical investors. A bearishly-inclined investor who pulls out of the present market in the hope of seeing the S&P revert to its “fair value” of 1500 is at least being realistic (whether you agree with the tactical call is obviously a different question). But a bearishly-inclined investor who pulls out of the present market on the expectation that the S&P will revert to its “fair value” of 1100 is being ridiculous. It’s fine to make calls for those kinds of levels–we all know that shit happens in markets. But let’s not make them on the basis of considerations that are as fickle and unreliable as “valuation.”

Comparing the Predictive Power of GAAP and Pro-Forma Constructions

Proponents of the Shiller CAPE will argue that the true measure of a valuation metric is not whether it makes intuitive or logical sense, but how well it correlates with future returns. As shown in the table below, the Pro-Forma CAPE and GAAP CAPE exhibit essentially the same correlation with future returns. The reason is that they are very similar for most of the historical data set. They only begin to appreciably deviate from each other in 2001.


Notice that for the period after 2001, the Pro-Forma CAPE correlation with future returns is slightly stronger. We don’t have data on 10 year total returns past 2003, and so this fact doesn’t tell us very much–the size of the data sample is only two years. However, it’s clear that as additional 10 year total return data come rolling in over the next few years, the Pro-Forma CAPE is going to continue to outperform the GAAP CAPE. Since 2001, the GAAP CAPE has been notably unreliable as a predictor of future returns. The Pro-Forma CAPE, in contrast, has been quite reliable.

At the bear market low of spring 2003, when the market was a reasonably attractive buy, the GAAP CAPE called it 40% overvalued. The Pro-Forma CAPE called it 12% overvalued, in line with the respectable–but not spectacular–returns that it ended up producing.

At the panic low of March 2009, when the the market was a screaming buy, the GAAP CAPE called it a mediocre 15% undervalued. The Pro-Forma CAPE called it 40% undervalued–much closer to what we would expect from a historical bear market low, and consistent with the fantastic returns that the market subsequently produced (north of 20% annualized).

Notably, in March 2009, on a pro-forma CAPE basis, the market traded down to early 1980s valuation levels. That is something we would expect, given that the early 1980s recession and the 2008-2009 recession were of similar intensity (with the latter arguably more intense). But on a GAAP CAPE basis, the market didn’t even come close to reaching early 1980s valuation levels–to the contrary, it barely broke below the valuation highs of the 1980s.

Changes in Dividend Payout Ratios

When the corporate sector earns money, it can pay the money out to its shareholders as dividends, or it can deploy the money internally to generate growth in future earnings (via investment, acquisitions, and share buybacks). All else equal, the more the corporate sector favors dividends, the lower the Shiller CAPE will be. The more it favors deploying earnings into investment, acquisitions, and buybacks, the higher the Shiller CAPE will be. That’s just the way the math of the Shiller CAPE works out–to the extent that earnings growth is reflected in present valuation, it is penalized.

To illustrate, suppose that we live in a zero growth, zero inflation world in which all stocks trade at 17 times earnings. Consider a hypothetical company in this world that pays out 75% of its earnings as a dividend, and uses the other 25% to buyback shares on the open market. As shown in the table below (using dummy data), the company’s Shiller CAPE for the period will end up being 18.16.


Now, consider the ten year history of a second company that is identical to the first company except for one feature: it pays out 25% of its earnings as a dividend, and devotes the other 75% to buybacks (the ratios are switched from before). As shown in the table below, the second company’s Shiller CAPE for the ten year period will end up being 20.65.


But these companies are identical in all respects–they have the exact same businesses and trade at the exact same P/E multiples–17. Why, then, does the Shiller CAPE for one of them end up being 14% higher than the other? The answer is that because the second company chooses internal reinvestment–buybacks–over dividends, it ends up with higher EPS growth over the period, and therefore a higher final share price (because they both trade at 17 times trailing earnings). Thus the second company ends up with a higher Shiller CAPE, even though its true valuation is the same.

The structure of the Shiller CAPE unfairly penalizes the corporate sector for reinvesting profit into EPS growth instead of paying dividends. But that is exactly what modern corporations do in comparison to corporations of the past: they provide a return to their shareholders by reinvesting profit rather than by distributing it. From 1954 to 1995, the S&P 500 dividend payout ratio averaged 52%, while the real EPS growth rate averaged 1.72%. From 1995 to 2013, the S&P 500 dividend payout ratio averaged 34%, while the real EPS growth rate averaged 4.9%.

To make comparisons between present and past values of the the Shiller CAPE, we need to normalize for differences in payout ratios. A crude way to do this is to note that at the current trailing twelve month P/E ratio–around 17–the difference between a 52% payout ratio (the average of 1954-1995) and a 34% payout ratio (the average since 1995) corresponds to around 1 point worth of Shiller CAPE. Taking 1 point off the current value of the Pro-Forma Shiller CAPE, we get an adjusted value of 19.63. On this basis, the market would need to correct to approximately 1550 to get back to its average valuation of the last 60 years. Unpleasant for longs, but hardly catastrophic. We were there just a few months ago.

A Permanently High Plateau

There is no external, divinely-imposed valuation level that the stock market has to take on. Rather, the stock market takes on whatever valuation level achieves the required equilibrium between those that want to get in it, and those that want to get out of it. At all times, every investor that wants to get in the market needs to connect with an investor that wants to get out of it. If there are too many that want to get in, and not enough that want to get out, the price will rise until the imbalance is relieved. If there are too many that went to get out, and not enough that want to get in, the price will fall until the same. The process is reflexive–investors want to get in or out based on where the price is and what it is doing, but they also make the price be where it is and do what it is doing, through their efforts.

For this reason, context–the set of environmental variables that shape investor outlook and risk appetite, and that influence the preference to be in or out, given the price–is crucial to normative claims about valuation. A valuation level that is “appropriate” in one context–adequate to achieve the required equilibrium–may not be “appropriate” in another.

Consider the following chart of the GAAP CAPE back to 1881:


Notice that the periods of below-average valuation, circled in black, generally involved three different types of environments: (1) war (destructive violence between countries or within a country), (2) high inflation (with tight monetary policy and high interest rates), and (3) financial crisis (with debt deflation and deep recession). These environments, which we will call The Big Three, represent classic, recurring challenges for the stock market. They create fear, pessimism and malaise on the part of investors, and serve as catalysts for deeply depressed valuations. We can see their damaging effects not only in U.S. market history, but in the history of stock markets all over the world.

The major bull markets of this century and the last century were each preceded by at least one of The Big Three. The bull market of the 1920s, for example, began after the victory in World War 1, as the economy moved out of the severely deflationary downturn of 1920 and 1921. The 1930s bull market began at the end of the Great Depression, after FDR took office and ended the gold standard, allowing the Federal Reserve (Fed) to inject desperately needed liquidity into the financial system. The 1950s bull market began in the years after World War 2, as the country worked through inflation challenges and monetary policy disputes and successfully transitioned into a peacetime economy. The bull market stumbled during combat in the Korean War, and then moved into full speed after the armistice of 1953-1954. The 1980s bull market began in 1982, when Paul Volcker finally conquered inflation (or so the narrative goes), making it possible for the Fed to shift to a looser monetary policy. The 2009 bull market began at the resolution of the acute phase of the Great Recession, as the Fed and the Federal Government aggressively collaborated to stabilize the banking system and restart the economy.

Notably, each of the ensuing bull markets involved a sustained period in which the economy saw the opposite of The Big Three: (1) peace, (2) low inflation with low or falling interest rates, particularly at the short end of the curve, and (3) stable, expansionary growth in an environment of financial stability. It’s hard to think of any time in history when these three conditions were met and where the economy was not in a rising bull market, with a “natural” bias for higher valuations.

Granted, the market saw corrections (1962, 1987, 2011) and there will surely be corrections in this market going forward. But there were never bear markets of the magnitude that would be necessary to bring the current Shiller CAPE back down to its long-term historical average. The only real exception to this point was the 2001-2003 downturn. But in that period, the market was unwinding a legitimate investment mania. Valuations did not “mean revert”–rather, they fell from egregious, unconscionable levels to levels that were just “expensive.” Recall that the theme of war was a relevant catalyst for the move: there were the 9/11 terrorist attacks, the operations in Afghanistan, and the invasion of Iraq, the runup to which helped push the market to its ultimate low for the period.

Investors that are patiently waiting for the Shiller CAPE to “mean revert” from the elevated level that it has hovered at over the past few decades, towards its long-term average, are implicitly calling for at least one of The Big Three to recur (either that, or something new that markets have never seen). The dominant presence of The Big Three in market history is the very reason that the long-term historical average of the Shiller CAPE has the value that it has–without them, its value would be higher, in line with or above the levels of the current era.

But why do The Big Three have to recur? If they do recur, why do they have to recur with the same frequency and intensity? If they don’t recur, why does some other bad thing have to occur in their place? Why can’t human beings make progress?

Think optimistically for a moment. What if large scale war is a thing of the past? The suggestion might sound naive, but there is significant evidence to support it. The human species has become dramatically less violent and war-prone as it has advanced intellectually, technologically, and economically. In the modern era of globalization, the idea of two advanced countries–the U.S. and China, for example–fighting each other in a real, no-kidding war is almost inconceivable.

What if low inflation and low interest rates are a permanent fixture of the modern economy, rather than something temporary? Trend inflation has been falling for over 30 years. Population growth is slowing, society is getting older, and therefore there’s less of a need to build and invest for the future. The process of building and investing for the future–a process that puts pressure on the present supply of labor–is arguably the main driver of inflation in a normal economy.

The current lack of inflation is made worse by advances in technology that have reduced the marginal value of labor, and by a process of globalization that has created an excess supply of cheap labor internationally. Moreover, a decline in union influence has significantly reduced the bargaining power of workers. If workers don’t have bargaining power, wage-price spirals can’t occur, and neither can meaningful inflation.

The Fed has absolute control over short-term interest rates, and significant control over long-term interest rates. It sets the former, and influences the latter, based on the level of inflationary pressure that it sees in the economy. If structural changes in the economy mean that there isn’t going to be meaningful inflationary pressure going forward, then interest rates can conceivably stay low forever.

What if deflationary financial crises are once-in-a-generation events? What if each time we have such crises, policymakers and the community of economists learn valuable lessons about how the system works, so that they can avert future crises, or at least address them more effectively?

Once again, the historical evidence provides strong support for such a view. The 2008 crisis had all of the makings of a new Great Depression. In terms of the amount of unstable private sector debt that existed, the starting point was actually worse than the Great Depression. But unlike in 1930, policymakers in 2008 quickly arrested the downward spiral–fiscally, monetarily, and especially through their controversial actions to stabilize the banking system. Now, here we are, only a few years later, in an economy that is growing healthily, with output well above the prior peak, arguably on the verge of the strongest expansion the country has seen since the mid 1990s. That’s a remarkable achievement, a reason for admitting that progress in economic policymaking is actually possible.

The reason that policymakers were able to bring about a different outcome in 2008 than in 1930 is that the field of economics advanced dramatically in the interim period. Policymakers learned the lessons of the Great Depression, and emerged with a much better understanding of how the system works. The good news is that in the present crisis–to include what is happening in Europe and Japan–new lessons are being learned. These lessons will help to avert future crises (or at least lessen their severity).

If you asked me what the biggest long-term threat to the U.S. economy is, my answer would be demographics. Over the next few decades, as our economy ages demographically, it runs the risk of going too far on the low inflation front–and entering deflation, which would eventually lead to financial crisis. But, again, it’s important to anticipate progress. Japan is experimentally fighting the problem of demographic deflation as we speak. It is going to learn critical lessons that we will be able to draw from should we ever face a similar situation.

Deflation is an unacceptable condition for an economy. If it occurs, policymakers will attack it with increasingly extreme monetary policies: “whatever it takes.” These policies tend to provoke higher than normal valuations. And so, ironically, even if the U.S. does eventually enter a Japanese-style deflation, Shiller bears are unlikely to be vindicated for very long.

It sounds overly ebullient to propose, as Irving Fisher famously did, that stocks have reached a new era of elevated valuation. But the point needs to be taken seriously, as there are strong reasons to believe it. The historical record leaves no other option but to admit that something about valuation has changed. The market has spent more than 20 years at a historically elevated Shiller CAPE. A 20+ year period is way too long to dismiss as an “outlier.”

Instead of assessing the valuation of the current market by making casual comparisons to the markets of the 1910s, 1930s, 1940s, and 1970s, we need to make comparisons to markets that shared relevant similarities with our own. Examples include the market of the late 1950s and 1960s, the market of the 1990s (excluding the mania that emerged after 1997), and the post-bubble market of the 2000s (excluding the financial crisis). If the current market were “attracted” to any kind of valuation, it would be to the kind of valuation seen in those periods, which were marked by peace, low-inflation growth, easy monetary policy, and financial stability (as opposed to wars, inflation spirals, punitively high interest rates, and financial panics.)

The following table shows the average and peak Pro-Forma Shiller CAPEs for each of the periods:


With the S&P at 1775, the current value of the Pro-Forma Shiller CAPE is 20.63. To compare the value with the 1955-1969 period, we need to adjust it for differences in the dividend payout ratio. From 1955-1969, the dividend payout ratio averaged 55%. At a P/E of 17, the difference between 55% and the current value of 34% amounts to roughly 1 point worth of Shiller CAPE. Subtracting, we get an adjusted Shiller CAPE of 19.63. That number almost perfectly matches the average for the 1955-1969 period, a period in which market valuations were generally fair and reasonable.

To reach the valuation high of the 1955-1969 period–23.88, which was registered in January 1966–the current S&P would have to rise to 2125. To reach the high of the 2003-2007 period, which was registered in January 2004, the S&P would have to rise by a slightly higher amount, to 2130 (note that there is no need for a dividend payout ratio adjustment in this case). To reach the high of the 1990-1997 period, which was registered in December 1997, the S&P would have to rise to 2900.

Admittedly, a call for Shiller CAPE to go to 33.82 and for the market to go to 2900 is pushing it–not a smart bet. But there’s no reason why the market shouldn’t at some point go back and touch the valuation peaks that it reached in the other comparable periods. It’s showing every sign of wanting to do so.

It’s also going to fall appreciably at some point, as all markets do, but it’s unlikely to fall in a way that would sustainably restore “historical averages” and vindicate Shiller bears. In their boycott, Shiller bears are making a blind bet on the mean reversion of a poorly constructed metric, without paying attention to context–the set of variables that drive the preferences of market participants to be in or out, and that determine the valuation that the market naturally gravitates towards. The outcome they are calling for requires the market’s context to return to the low points–war, tight money inflation, financial crisis–of prior eras. The reality of human progress reduces both the likelihood that such a return will occur, and, in the specific case of financial crisis, the intensity and duration of the pain that it would bring.

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NYT: The Biology of Risk


The Biology of Risk

SIX years after the financial meltdown there is once again talk about market bubbles. Are stocks succumbing to exuberance? Is real estate? We thought we had exorcised these demons. It is therefore with something close to despair that we ask: What is it about risk taking that so eludes our understanding, and our control?

Part of the problem is that we tend to view financial risk taking as a purely intellectual activity. But this view is incomplete. Risk is more than an intellectual puzzle — it is a profoundly physical experience, and it involves your body. Risk by its very nature threatens to hurt you, so when confronted by it your body and brain, under the influence of the stress response, unite as a single functioning unit. This occurs in athletes and soldiers, and it occurs as well in traders and people investing from home. The state of your body predicts your appetite for financial risk just as it predicts an athlete’s performance.

If we understand how a person’s body influences risk taking, we can learn how to better manage risk takers. We can also recognize that mistakes governments have made have contributed to excessive risk taking.

Consider the most important risk manager of them all — the Federal Reserve. Over the past 20 years, the Fed has pioneered a new technique of influencing Wall Street. Where before the Fed shrouded its activities in secrecy, it now informs the street in as clear terms as possible of what it intends to do with short-term interest rates, and when. Janet L. Yellen, the chairwoman of the Fed, declared this new transparency, called forward guidance, a revolution; Ben S. Bernanke, her predecessor, claimed it reduced uncertainty and calmed the markets. But does it really calm the markets? Or has eliminating uncertainty in policy spread complacency among the financial community and actually helped inflate market bubbles?

We get a fascinating answer to these questions if we turn from economics and look into the biology of risk taking.

ONE biological mechanism, the stress response, exerts an especially powerful influence on risk taking. We live with stress daily, especially at work, yet few people truly understand what it is. Most of us tend to believe that stress is largely a psychological phenomenon, a state of being upset because something nasty has happened. But if you want to understand stress you must disabuse yourself of that view. The stress response is largely physical: It is your body priming itself for impending movement.

As such, most stress is not, well, stressful. For example, when you walk to the coffee room at work, your muscles need fuel, so the stress hormones adrenaline and cortisol recruit glucose from your liver and muscles; you need oxygen to burn this fuel, so your breathing increases ever so slightly; and you need to deliver this fuel and oxygen to cells throughout your body, so your heart gently speeds up and blood pressure increases. This suite of physical reactions forms the core of the stress response, and, as you can see, there is nothing nasty about it at all.

Far from it. Many forms of stress, like playing sports, trading the markets, even watching an action movie, are highly enjoyable. In moderate amounts, we get a rush from stress, we thrive on risk taking. In fact, the stress response is such a healthy part of our lives that we should stop calling it stress at all and call it, say, the challenge response.

This mechanism hums along, anticipating challenges, keeping us alive, and it usually does so without breaking the surface of consciousness. We take in information nonstop and our brain silently, behind the scenes, figures out what movement might be needed and then prepares our body. Many neuroscientists now believe our brain is designed primarily to plan and execute movement, that every piece of information we take in, every thought we think, comes coupled with some pattern of physical arousal. We do not process information as a computer does, dispassionately; we react to it physically. For humans, there is no pure thought of the kind glorified by Plato, Descartes and classical economics.

Our challenge response, and especially its main hormone cortisol (produced by the adrenal glands) is particularly active when we are exposed to novelty and uncertainty. If a person is subjected to something mildly unpleasant, like bursts of white noise, but these are delivered at regular intervals, they may leave cortisol levels unaffected. But if the timing of the noise changes and it is delivered randomly, meaning it cannot be predicted, then cortisol levels rise significantly.

Uncertainty over the timing of something unpleasant often causes a greater challenge response than the unpleasant thing itself. Sometimes it is more stressful not knowing when or if you are going to be fired than actually being fired. Why? Because the challenge response, like any good defense mechanism, anticipates; it is a metabolic preparation for the unknown.

You may now have an inkling of just how central this biology is to the financial world. Traders are immersed in novelty and uncertainty the moment they step onto a trading floor. Here they encounter an information-rich environment like none other. Every event in the world, every piece of news, flows nonstop onto the floor, showing up on news feeds and market prices, blinking and disappearing. News by its very nature is novel, adds volatility to the market and puts us into a state of vigilance and arousal.

I observed this remarkable call and echo between news and body when, after running a trading desk on Wall Street for 13 years, I returned to the University of Cambridge and began researching the neuroscience of trading.


How the Fed Tried to Rein in Volatility


In one of my studies, conducted with 17 traders on a trading floor in London, we found that their cortisol levels rose 68 percent over an eight-day period as volatility increased. Subsequent, as yet unpublished, studies suggest to us that this cortisol response to volatility is common in the financial community. A question then arose: Does this cortisol response affect a person’s risk taking? In a follow-up study, my colleagues from the department of medicine pharmacologically raised the cortisol levels of a group of 36 volunteers by a similar 69 percent over eight days. We gauged their risk appetite by means of a computerized gambling task. The results, published recently in the Proceedings of the National Academy of Sciences, showed that the volunteers’ appetite for risk fell 44 percent.

Most models in economics and finance assume that risk preferences are a stable trait, much like your height. But this assumption, as our studies suggest, is misleading. Humans are designed with shifting risk preferences. They are an integral part of our response to stress, or challenge.

When opportunities abound, a potent cocktail of dopamine — a neurotransmitter operating along the pleasure pathways of the brain — and testosterone encourages us to expand our risk taking, a physical transformation I refer to as “the hour between dog and wolf.” One such opportunity is a brief spike in market volatility, for this presents a chance to make money. But if volatility rises for a long period, the prolonged uncertainty leads us to subconsciously conclude that we no longer understand what is happening and then cortisol scales back our risk taking. In this way our risk taking calibrates to the amount of uncertainty and threat in the environment.

Under conditions of extreme volatility, such as a crisis, traders, investors and indeed whole companies can freeze up in risk aversion, and this helps push a bear market into a crash. Unfortunately, this risk aversion occurs at just the wrong time, for these crises are precisely when markets offer the most attractive opportunities, and when the economy most needs people to take risks. The real challenge for Wall Street, I now believe, is not so much fear and greed as it is these silent and large shifts in risk appetite.

I consult regularly with risk managers who must grapple with unstable risk taking throughout their organizations. Most of them are not aware that the source of the problem lurks deep in our bodies. Their attempts to manage risk are therefore comparable to firefighters’ spraying water at the tips of flames.

THE Fed, however, through its control of policy uncertainty, has in its hands a powerful tool for influencing risk takers. But by trying to be more transparent, it has relinquished this control.

Forward guidance was introduced in the early 2000s. But the process of making monetary policy more transparent was in fact begun by Alan Greenspan back in the early 1990s. Before that time the Fed, especially under Paul A. Volcker, operated in secrecy. Fed chairmen did not announce rate changes, and they felt no need to explain themselves, leaving Wall Street highly uncertain about what was coming next. Furthermore, changes in interest rates were highly volatile: When Mr. Volcker raised rates, he might first raise them, cut them a few weeks later, and then raise again, so the tightening proceeded in a zigzag. Traders were put on edge, vigilant, never complacent about their positions so long as Mr. Volcker lurked in the shadows. Street wisdom has it that you don’t fight the Fed, and no one tangled with that bruiser.

Under Mr. Greenspan, the Fed became less intimidating and more transparent. Beginning in 1994 the Fed committed to changing fed funds only at its scheduled meetings (except in emergencies); it announced these changes at fixed times; and it communicated its easing or tightening bias. Mr. Greenspan notoriously spoke in riddles, but his actions had no such ambiguity. Mr. Bernanke reduced uncertainty even further: Forward guidance detailed the Fed’s plans.

Under both chairmen fed funds became far less erratic. Whereas Mr. Volcker changed rates in a volatile fashion, up one week down the next, Mr. Greenspan and Mr. Bernanke raised them in regular steps. Between 2004 and 2006, rates rose .25 percent at every Fed meeting, without fail… tick, tick, tick. As a result of this more gradualist Fed, volatility in fed funds fell after 1994 by as much as 60 percent.

In a speech to the Cato Institute in 2007, Mr. Bernanke claimed that minimizing uncertainty in policy ensured that asset prices would respond “in ways that further the central bank’s policy objectives.” But evidence suggests that quite the opposite has occurred.

Cycles of bubble and crash have always existed, but in the 20 years after 1994, they became more severe and longer lasting than in the previous 20 years. For example, the bear markets following the Nifty Fifty crash in the mid-70s and Black Monday of 1987 had an average loss of about 40 percent and lasted 240 days; while the dot-com and credit crises lost on average about 52 percent and lasted over 430 days. Moreover, if you rank the largest one-day percentage moves in the market over this 40-year period, 76 percent of the largest gains and losses occurred after 1994.

I suspect the trends in fed funds and stocks were related. As uncertainty in fed funds declined, one of the most powerful brakes on excessive risk taking in stocks was released.

During their tenures, in response to surging stock and housing markets, both Mr. Greenspan and Mr. Bernanke embarked on campaigns of tightening, but the metronome-like ticking of their rate increases was so soothing it failed to dampen exuberance.

There are times when the Fed does need to calm the markets. After the credit crisis, it did just that. But when the economy and market are strong, as they were during the dot-com and housing bubbles, what, pray tell, is the point of calming the markets? Of raising rates in a predictable fashion? If you think the markets are complacent, then unnerve them. Over the past 20 years the Fed may have perfected the art of reassuring the markets, but it has lost the power to scare. And that means stock markets more easily overshoot, and then collapse.

The Fed could dampen this cycle. It has, in interest rate policy, not one tool but two: the level of rates and the uncertainty of rates. Given the sensitivity of risk preferences to uncertainty, the Fed could use policy uncertainty and a higher volatility of funds to selectively target risk taking in the financial community. People running factories or coffee shops or drilling wells might not even notice. And that means the Fed could keep the level of rates lower than otherwise to stimulate the economy.

IT may seem counterintuitive to use uncertainty to quell volatility. But a small amount of uncertainty surrounding short-term interest rates may act much like a vaccine immunizing the stock market against bubbles. More generally, if we view humans as embodied brains instead of disembodied minds, we can see that the risk-taking pathologies found in traders also lead chief executives, trial lawyers, oil executives and others to swing from excessive and ill-conceived risks to petrified risk aversion. It will also teach us to manage these risk takers, much as sport physiologists manage athletes, to stabilize their risk taking and to lower stress.

And that possibility opens up exciting vistas of human performance.

John Coates is a research fellow at Cambridge who traded derivatives for Goldman Sachs and ran a desk for Deutsche Bank. He is the author of “The Hour Between Dog and Wolf: How Risk Taking Transforms Us, Body and Mind.”


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William White: I see speculative bubbles like in 2007

William White: I see speculative bubbles like in 2007



William R. White, the former chief economist of the Bank for International Settlements, warns of grave adverse effects of the ultra loose monetary policy.


William White is worried. The former chief economist of the Bank for International Settlements is highly sceptical of the ultra loose monetary policy that most central banks are still pursuing. «It all feels like 2007, with equity markets overvalued and spreads in the bond markets extremely thin», he warns.

Mr. White, all the major central banks have been running expansive monetary policies for more than five years now. Have you ever experienced anything like this?
The honest truth is no one has ever seen anything like this. Not even during the Great Depression in the Thirties has monetary policy been this loose. And if you look at the details of what these central banks are doing, it’s all very experimental. They are making it up as they go along. I am very worried about any kind of policies that have that nature.

But didn’t the extreme circumstances after the collapse of Lehman Brothers warrant these extreme measures?
Yes, absolutely. After Lehman, many markets just seized up. Central bankers rightly tried to maintain the basic functioning of the system. That was good crisis management. But in my career I have always distinguished between crisis prevention, crisis management, and crisis resolution. Today, the Fed still acts as if it was in crisis management. But we’re six years past that. They are essentially doing more than what they did right in the beginning. There is something fundamentally wrong with that. Plus, the Fed has moved to a completely different motivation. From the attempt to get the markets going again, they suddenly and explicitly started to inflate asset prices again. The aim is to make people feel richer, make them spend more, and have it all trickle down to get the economy going again. Frankly, I don’t think it works, and I think this is extremely dangerous.

So, the first quantitative easing in November 2008 was warranted?

But they should have stopped these kinds of policies long ago?
Yes. But here’s the problem. When you talk about crisis resolution, it’s about attacking the fundamental problems that got you into the trouble in the first place. And the fundamental problem we are still facing is excessive debt. Not excessive public debt, mind you, but excessive debt in the private and public sectors. To resolve that, you need restructurings and write-offs. That’s government policy, not central bank policy. Central banks can’t rescue insolvent institutions. All around the western world, and I include Japan, governments have resolutely failed to see that they bear the responsibility to deal with the underlying problems. With the ultraloose monetary policy, governments have no incentive to act. But if we don’t deal with this now, we will be in worse shape than before.

But wouldn’t large-scale debt write-offs hurt the banking sector again?
Absolutely. But you see, we have a lot of zombie companies and banks out there. That’s a particular worry in Europe, where the banking sector is just a continuous story of denial, denial and denial. With interest rates so low, banks just keep evergreening everything, pretending all the money is still there. But the more you do that, the more you keep the zombies alive, they pull down the healthy parts of the economy. When you have made bad investments, and the money is gone, it’s much better to write it off and get fifty percent than to pretend it’s still there and end up getting nothing. So yes, we need more debt reduction and more recapitalization of the banking system. This is called facing up to reality.

Where do you see the most acute negative effects of this monetary policy?
The first thing I would worry about are asset prices. Every asset price you could think of is in very odd territory. Equity prices are extremely high if you at valuation measures such as Tobin’s Q or a Shiller-type normalized P/E. Risk-free bond rates are at enormously low levels, spreads are very low, you have all these funny things like covenant-lite loans again. It all looks and feels like 2007. And frankly, I think it’s worse than 2007, because then, it was a problem of the developed economies. But in the past five years, all the emerging economies have imported our ultra-low policy rates and have seen their debt levels rise. The emerging economies have morphed from being a part of the solution to being a part of the problem.

Do you see outright bubbles in financial markets?
Yes, I do. Investors try to attribute the rising stock markets to good fundamentals. But I don’t buy that. People are caught up in the momentum of all the liquidity that is provided by the central banks. This is a liquidity driven thing, not based on fundamentals.

So are we mostly seeing what the Fed has been doing since 1987 – provide liquidity and pump markets up again?
Absolutely. We just saw the last chapter of that long history. This is the last of a whole series of bubbles that have been blown. In the past, monetary policy has always succeeded in pulling up the economy. But each time, the Fed had to act more vigorously to achieve its results. So, logically, at a certain point, it won’t work anymore. Then we’ll be in big trouble. And we will have wasted many years in which we could have been following better policies that would have maintained growth in much more sustainable ways. Now, to make you feel better, I said the same in 1998, and I was way too early.

What about the moral hazard of all this?
The fact of the matter is that if you have had 25 years of central bank and government bailout whenever there was a problem, and the bankers come to appreciate that fact, then we are back in a world where the banks get all the profits, while the government socializes all the losses. Then it just gets worse and worse. So, in terms of curbing the financial system, my own sense is that all of the stuff that has been done until now, while very useful, Basel III and all that, is not going to be sufficient to deal with the moral hazard problem. I would have liked to see a return to limited banking, a return to private ownership, a return to people going to prison when they do bad things. Moral hazard is a real issue.

Do you have any indication that the Yellen Fed will be different than the Greenspan and Bernanke Fed?
Not really. The one person in the FOMC that was kicking up a real fuss about asset bubbles was Governor Jeremy Stein. Unfortunately, he has gone back to Harvard.

The markets seem to assume that the tapering will run very smoothly, though. Volatility, as measured by the Vix index, is low.
Don’t forget that the Vix was at record low in 2007. All that liquidity raises the asset prices and lowers the cost of insurance. I see at least three possible scenarios how this will all work out. One is: Maybe all this monetary stuff will work perfectly. I don’t think this is likely, but I could be wrong. I have been wrong so many times before. So if it works, the long bond rates can go up slowly and smoothly, and the financial system will adapt nicely. But even against the backdrop of strengthening growth, we could still see a disorderly reaction in financial markets, which would then feed back to destroy the economic recovery.

We are such a long way away from normal long term interest rates. Normal would be perhaps around four percent. Markets have a tendency to rush to the end point immediately. They overshoot. Keynes said in late Thirties that the long bond market could fluctuate at the wrong levels for decades. If fears of inflation suddenly re-appear, this can move interest rates quickly. Plus, there are other possible accidents. What about the fact that maybe most of the collateral you need for normal trading is all tied up now? What about the fact that the big investment dealers have got inventories that are 20 percent of what they were in 2007? When things start to move, the inventory for the market makers might not be there. That’s a particular worry in fields like corporate bonds, which can be quite illiquid to begin with. I’ve met so many people who are in the markets, thinking they are absolutely brilliantly smart, thinking they can get out in the right time. The problem is, they all think that. And when everyone races for the exit at the same time, we will have big problems. I’m not saying all of this will happen, but reasonable people should think about what could go wrong, even against a backdrop of faster growth.

And what is the third scenario?
The strengthening growth might be a mirage. And if it does not materialize, all those elevated prices will be way out of line of fundamentals.

Which of the major central banks runs the highest risk of something going seriously wrong?
At the moment what I am most worried about is Japan. I know there is an expression that the Japanese bond market is called the widowmaker. People have bet against it and lost money. The reason I worry now is that they are much further down the line even than the Americans. What is Abenomics really? As far as I see it, they print the money and tell people that there will be high inflation. But I don’t think it will work. The Japanese consumer will say prices are going up, but my wages won’t. Because they haven’t for years. So I am confronted with a real wage loss, and I have to hunker down. At the same time, financial markets might suddenly not want to hold Japanese Government Bonds anymore with a perspective of 2 percent inflation. This will end up being a double whammy, and Japan will just drop back into deflation. And now happens what Professor Peter Bernholz wrote in his latest book. Now we have a stagnating Japanese economy, tax revenues dropping like a stone, the deficit already at eight percent of GDP, debt at more than 200 percent and counting. I have no difficulty in seeing this thing tipping overnight into hyperinflation. If you go back into history, a lot of hyperinflations started with deflation.

Many people have warned of inflation in the past five years, but nothing has materialized. Isn’t the fear of inflation simply overblown?
One reason we don’t see inflation is because monetary policy is not working. The signals are not getting through. Consumers and corporates are not responding to the signals. We still have a disinflationary gap. There has been a huge increase in base money, but it has not translated into an increase in broader aggregates. And in Europe, the money supply is still shrinking. My worry is that at some point, people will look at this situation and lose confidence that stability will be maintained. If they do and they do start to fear inflation, that change in expectations can have very rapid effects.

The Swiss National Bank has increased its balance sheet the most in relation to Swiss GDP. Should the Swiss be worried?
Yes, I do think you should be concerned. But at the same time, remind you, what you have here is a very different beast from what you are seeing in other countries. The SNB has not increased base money because they wanted to pump up the economy, but to prevent the Swiss Franc from appreciating too much. And that was not a monetary, but a political decision. I would say barring some major shocks outside, what they have done was the right thing to do and highly successfully implemented. But you cannot deny the arithmetics that the balance sheet is huge, much of it in foreign currency, and if something bad happens outside, and then Switzerland will look like a refuge again, the pressure on the Franc will be huge.

While that policy is in place, Swiss domestic interest rates are too low. Should the SNB be worried about a real estate bubble?
Yes, absolutely. You are caught between a rock and a hard place. To prevent the Franc from going up, you have to introduce too easy monetary policy, and you don’t like that either. So the SNB has to introduce macroprudential measures, trying to cool off the real estate market. That’s the right thing to do, because housing tends to be the big thing that goes wrong when you have too easy financial conditions.


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