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29th June 2015

The only game worth playing

I cannot leave this subject as though its just treatment wholly depended either on our own
pledges or economic facts. The policy of reducing Germany to servitude for a generation, of
degrading the lives of millions of human beings, and of depriving a whole nation of happiness
should be abhorrent and detestable, - abhorrent and detestable, even if it were possible, even if it
enriched ourselves, even if it did not sow the decay of the whole civilized life of Europe. Some
preach it in the name of Justice. In the great events of man's history, in the unwinding of the
complex fates of nations Justice is not so simple. And if it were, nations are not authorized, by
religion or by natural morals, to visit on the children of their enemies the misdoings of parents of
rulers.
- John Maynard Keynes, The Economic Consequences of the Peace, cited by George
Cooper.
Probably the most powerful metaphor in the otherwise dismal history of economics is Frdric
Bastiats broken window fallacy. It runs as follows. A shopkeepers son happens to break one of his
windows. It attracts a crowd. Pretty soon they say to each other, Its an ill wind that blows
nobody any good. People need to make a living. This will be good news for the glazier. A glazier
duly arrives, and is paid six francs for his repairs. Perhaps we should break more windows. Money
will circulate throughout the economy. Glaziers will benefit.
Bastiat then addresses the crowd directly:
Stop there ! Your theory is confined to that which is seen; it takes no account of that which is
not seen.
The crowd sees and hears the six francs jangling in the glaziers pocket. They anticipate the
economic frenzy that will develop when those six francs are spent. What the crowd does not see
is what the shopkeeper might have done with those six francs that he has now handed over to the
glazier. His employment of those six francs in some more productive way is not seen, because it
can now never happen.
If that which is not seen is taken into consideration, because it is a negative fact, as well as that
which is seen, because it is a positive fact, it will be understood that neither industry in general,
nor the sum total of national labour, is affected, whether windows are broken or not.

Bastiats metaphor only gets more powerful over time as the world economy gets more and more
financialised, and as more and more capital flows in ways that are somewhat less than fully
transparent. But the worlds a big place it would be foolish to think that we can always see
whats going on, let alone take account of what, per Bastiat, we plainly cannot see.
So there will no doubt be plenty of wild theorising flying around as the latest act in the ongoing
Greek tragedy plays out in the financial markets. What we do know, though, is that after the
bailouts of 2010, Greek debt of questionable value which had been held predominantly by French
and German banks of similarly questionable value, through the good offices of the European
Commission, the ECB and the IMF, suddenly became the liability of Europes taxpayers. None of
this was done in any way that can be described as democratic. It was done by unelected
bureaucrats. But it was clearly done for political reasons the euro zone project stopped being
about economic matters, if it ever even was, some years back.
Another European whose observations are worthy of note in the midst of this crisis is the
Austrian economist Leopold Kohr. Whereas the Scottish moral philosopher Adam Smith wrote
about the wealth of nations, Kohrs magnum opus was entitled The breakdown of nations. Kohr
was born in the tiny village of Oberndorf in central Austria. The size of his birthplace would prove
to be a constant influence on Kohrs world outlook. Kohr believed that there were unavoidable
limits to the expansion of societies:
..social problems have the unfortunate tendency to grow at a geometric ratio with the growth of
an organism of which they are a part, while the ability of man to cope with them, if it can be
extended at all, grows only at an arithmetic ratio.
As far as Leopold Kohr was concerned, only small states could constitute true democracies,
because only in small states could the citizen have direct influence over the governing authorities.
Probably the best example of such devolved and localised democracy in Europe today is
Switzerland which continues, not incidentally, to be one of the most successful economies in the
world, despite in huge opposition to the conventional wisdom on the topic maintaining a
strong currency.
We have ridiculed the many little states, wrote Kohr, sadly,
Now we are terrorised by their few successors.
Professor Albert Bartlett of the University of Colorado was another thinker wary of gigantism.
His 70 minute presentation Arithmetic, Population and Energy remains the most impressive
presentation on YouTube I have ever seen.
Professor Bartletts thesis was that mankinds biggest failure is our inability to understand the
power of the exponential function. The exponential function describes anything that grows by a
fixed percentage over time. He uses the example of bacteria growing in a bottle. At 11 oclock the
bottle is empty, bar one bacterium. By 12 oclock the bottle is full. The doubling time the time it
takes for the bacteria to double in number is a minute. He then asks: at what time is the bottle
half full ?
The answer may surprise you: at just one minute to mid-day.

What applies to bacteria in bottles also applies to the human population on our planet and to the
worlds natural resources. To cut to Bartletts chase, he asks:
Can you think of any problem in any area of human endeavour on any scale, from microscopic to
global, whose long term solution is in any demonstrable way aided, assisted or advanced by further
increases in population locally, nationally or globally ? As he states, equally starkly,
Continued growth past maturity for any entity becomes obesity or cancer.
Contrary to popular belief and widespread political deception, the world has seen no great
deleveraging since the financial crisis. As McKinsey recently pointed out, global debt has actually
risen since 2007 by some $57 trillion.
And debt is a tricky asset class. While it constitutes an asset to the holder, it is clearly a liability for
the issuer, who has every incentive under the sun to devalue it. That conflict of interests is bad
enough. It is made worse by the fact that investment in debt is conducted almost exclusively by
institutional players fund managers who, at a personal level, have little or no skin in the game,
and who conduct their investment operations almost entirely in obedience to the illogic of bond
indexation, whereby the largest components of a bond index are the most heavily indebted and
therefore least creditworthy issuers of that debt.
Bastiat showed that what we think we see is often dwarfed by the impact of things we cannot see
and in some cases cannot even begin to understand. The tectonic plates of the global debt market,
we suspect, are starting to shift, in what may become some very uncomfortable ways, that are
likely to hugely imperil the capital of bondholders, creditors and others not necessarily directly
linked to the bond market at all.
The very role of bonds in 2015 has become hopelessly distorted. This is an asset class historically
associated with the generation of income and the preservation of capital. Interest rates are now so
derisory and so politicised that the purpose and function of bonds in an investment portfolio no
longer has any validity.
To us the conclusion is clear. If you cannot understand the game, then do not play the game. The
rational investment answer lies not in overvalued credit markets but in undervalued equity
markets, provided they can be found. Notwithstanding the likely market volatility associated with
the ongoing Greek black comedy, high quality and value stocks seem, to our way of thinking, to
be the only game in town that is really worth playing any more.
Tim Price is Director of Investment at PFP Wealth Management and co-manager of the VT Price Value
Portfolio (www.pricevaluepartners.com).