Another Optimist

In this morning's Wall Street Journal, Andy Kessler writes that there may be a way for the Federal Reserve to exit the current monetary expansion without killing the economic recovery. Not only that, he thinks his plan could avoid rapid inflation and make bank panics a thing of the past. His idea is to have the Fed increase the amount of reserves that banks are required to hold, thereby reducing the amount of leverage in the banking system and giving the fed more control over money supply.

I hope Andy is on to something and that Bernanke is thinking along the same lines. A more stable banking system would certainly help all of us, and I am all in favor of solutions that require less regulation and bureaucracy.

An Optimist

I read this article, "Why the Recovery Will be Robust" in yesterday's Wall Street Journal. What struck me is that this is the first time I've heard any economist claim that we will have a strong recovery. The general consensus has been that the recovery will be mild. I really have no clue how strong or weak the recovery will be, but I'm am often skeptical of consensus opinions. If everyone says the recovery will be weak, then I won't be surprised if it's stronger than expected.

I also like the article because it gives a pretty straightforward and simple explanation of how economies work. Here is a good example:

"The popular idea that the economy is driven by "stimulus" spending—as if politicians could capture and bring in resources from outside the economic system—is mistaken. Economies grow as the result of capital being put to work. Capital is plentiful. But it retreats in times of turbulence and uncertainty, coming back to work when uncertainty abates."

I agree that capital is currently plentiful, thanks to all of the actions by the Federal Reserve. Let's hope that businesses do a good job putting that capital back to work, resulting in a stronger than expected recovery.

Good News?

The big news of the day is that US GDP rose 5.7% in the 4th quarter of 2009. However, with unemployment at 10%, the economy still has a way to go before we would call it "recovered", but we need to start somewhere.

Here are some economists reactions to the GDP news, some more positive than others. Also, here is an explanation of how the GDP increase was due in part to slower draw downs of inventories.

Active Management Fails Again

Every six months, S&P publishes the S&P Persistence Scorecard, the purpose of which is to measure whether mutual funds managers are able to consistently outperform their peers. As you may guess, the results are not very good for active managers. According to the S&P study, "very few funds manage to consistently repeat top-half and top-quartile performance." In other words, fund managers who are better than average this year will likely be worse than average next year.

This is why we believe so strongly in passive management, which is all about lowering investment costs. Why pay high fees to active managers when they are not able to consistently achieve superior investment returns? We think the better approach is to keep costs down and to keep our actual returns as close as possible to the asset class in which we are investing. This means that we will be giving up the chance of having higher returns then our benchmark, but we are also eliminating the chance of having lower returns.

Lowering investment costs is why we are such big fans of Dimensional Fund Advisors (DFA), because they are so focused on lowering costs throughout the investment process. DFA has just redesigned their public website, and I urge you to give it a look if you haven't done so recently. There is lots of good information on how DFA adds value, like this explanation of "portfolio engineering".

One final thought on active vs. passive management. Last year, Professors Eugene Fama and Ken French did an academic study looking at luck vs. skill in mutual fund management. I have seen Professor French lecture on this topic, and he says that when statistically analyzing mutual fund returns, the results of active managers "look a lot like luck." Which leads me to the conclusion, why pay for luck?

Economics Rap

The video below has been all over the internet today, although I'm sure most of the viewers have been "economics geeks" like me. It's very creative and funny, worth the six minutes it takes to watch

The is the website of the group that produced the video, including a bunch of info on John Maynard Keynes and F.A. Hayek, the two "stars" of the video and two of the most important economic thinkers of all time.

Inflation Monster

This article appeared in The New York Time over the weekend, and it was written by Harvard Economist. Greg Mankiw. The first sentence of the article asks "Is galloping inflation around the corner?" and that does a great job introducing what the article is about. The risk of future inflation is something I have posted about before, and it is something we discuss with all of our clients.

As the economy recovers, the Federal Reserve will be engaged in a very delicate balancing act of trying to avoid high inflation while keeping the recovery from losing steam, all in the face of large government budget deficits. I don't know how it will turn out, but I do know that high inflation wreaks havoc on personal retirement plans, as it is difficult for retirement incomes to keep pace with rapidly rising prices. That is why during retirement it is not advisable to put all of your assets in "safe" investments like cash and bonds, because those assets will not produce returns greater than inflation when the inflation monster does indeed arrive.

Here is the last paragraph of Professor Mankiw's article:

"Investors snapping up 30-year Treasury bonds paying less than 5 percent are betting that the Fed will keep these inflation risks in check. They are probably right. But because current monetary and fiscal policy is so far outside the bounds of historical norms, it’s hard for anyone to be sure. A decade from now, we may look back at today’s bond market as the irrational exuberance of this era."

Mad About Trade

I just finished reading this book, "Mad About Trade"

The author does an excellent job of laying out the arguments for why trade benefits most Americans and of disproving many of the myths about how free trade is responsible for job losses, lower incomes, etc. I absolutely recommend the book for anyone who is concerned that America is losing its way in the global economy. The book's conclusion sums it up perfectly:

"Free trade confidently embraces the future. It affirms that Americans have much to offer the world and much to gain from collaborating with people in other countries as customers, suppliers, business partners, and friends. Free trade unites us with other people in an ever widening "community of work" that provides a powerful alternative to conflict and war. Free trade embodies a policy of hope rather than fear."