The Doctrine of the Mean

I decided to use this as the end of my series of blogs. Because this, from my point of view, is the attitude we should have to deal with the problems in investing, policy making and life. It is a way to solve most of the problems in any kind of conflicts.

 

And it is the Doctrine of the Mean. “The Master [Confucius] said: The virtue embodied in the doctrine of the Mean is of the highest order. But it has long been rare among people.” The Doctrine of the Mean is a text rich with symbolism and guidance to perfecting oneself. The mean is also described as the 'unwobbling pivot' or 'chung yung'. Chung means bent neither one way or another, and yung represents unchanging. In James Legge's translation of the text, the goal of the mean is to maintain balance and harmony from directing the mind to a state of constant equilibrium. The person who follows the mean is on a path of duty and must never leave it. A superior person is cautious, a gentle teacher and shows no contempt for their inferiors. They always do what is natural according to their status in the world. The Doctrine of the Mean represents moderation, rectitude, objectivity, sincerity, honesty and propriety. The guiding principle is that one should never act in excess.

 

And here are two stories to help to interpret it:

Once there was a person who lives off on planting the trees. His trees are of very good quality and can be used as rooftree. And thus he was very wealthy by selling the wood. His neighbourhood mimic it and also plant a lot of trees. But what he did is just cut the tree before it is fully mature. And the product of him can only be used as firewood. As a result, he never became rich.

A black horse was walking along the river and he saw a bout flowing on it. The horse laughed at it because the boat was flowing very slowly. He began to run very fast as a kind of flaunting. But after a long time the horse was so tired and died. The boat, on the other hand, travelling peacefully, passing by the corpse of the horse and walked away.

 

From the dot Com Bubble, we can see the traces of many crises during the past. And without any doubt, it will repeat again and again in different forms. And that is because of something unchanged deep into the humanity. The current financial system, from this point of view, is fragile. It is inherently unstable. Although the Doctrine of the Mean cannot provide a practical solution to solve the many paradoxes in our financial system. But it should be an idea that we need to keep in mind when rethinking the economic policy to ensure long term growth in the future.

 

 

Buffett at Sun Valley, 1999

Every time I read this speech it makes me blood boiling. It was delivered by Buffett in 1999 during the Sun Valley. Usually, for Buffett, this is a good time to have a family gathering. Of course golf, bridge and social activities. In 1999, when the Dow-Jones is at more than 10000 point, tripled in half a year, Buffett, who is known as an investor not interested in high tech companies at that time was thought as outdated.

 

In fact, Buffett had prepared for weeks on this speech. He took this speech quite serious. And this is the first time for him in the 30 years to predict the market. Buffett nearly bought no shares of internet companies at that time. Before reading the intelligent investor, I thought his attitude about internet companies must be a story full of conspiracies. But after having read the book, I have changed my opinion. Not to buy the shares of Dot Com companies should be a natural behaviour that is consistent with Graham’s thought. I listed the speech separately because these are the insights of investors rather than a more academic one.

 

And here is the speech

 

Finally, at the end of the speech, with several jokes made the silence was broken. But after a while, resentment has been spread in the house. Unlike most of the people in the hall, some body thought they were benefited from the speech. “Basic knowledge about stock market in one lesson.” Gates said.

 

As an investor, Buffett is very sensitive to bubbles. He used to divide asset into three types: fixed income asset (the risk is mainly caused by the inflation); asset that is not productive like gold; asset that can produce fortune and the best example is a farm (asset with less threaten of inflation is preferred. Companies like Coca Cola is preferred than the utilities in that they will not be greatly influenced during high inflation). In the general meeting of shareholders of 2011, Buffett expressed his concern about the bubble of gold. During the meeting, he was queried by some shareholders about why he didn’t buy some gold to hedge the risk during that time when it was of relatively high inflation. From his point of view, gold is not productive. And it is expensive. Asset with reasonable cause to hold at the first can became bubble if having been hyped excessively. Buying gold is like gambling, he said you can only hope somebody else to buy it rather than it manifests itself with producing value and wealth. Nearly rigid.

 

 

What Caused the Dot Com Bubble: 3: Changing of the Conventional Wisdom of the US Society

In this chapter we’ll talk about more subtle things, which lead to some irrational behaviours of the investors during the Dot Com Bubble. Irrationalities of the investors is a very important reason for the formation of the dot com bubble. And several kinds of typical psychological failings like overconfidence, herding, mania and new paradigm mentality did turned up in the dot com bubble.

 

Buffett ever said that he was told by Graham that a good idea will always bring you with more troubles than a bad one, because people always forget about the limiting condition of applying the good idea.

 

Brennan (2004) suggested that before the Dot Com Bubble, there are several changes in the conventional wisdom. And here are the three main changes:

 

The first one is caused by the mean variance portfolio theory suggested by Markowitz. This made people more willing to buy diversified market portfolios rather to pick some ‘good’ stocks and made people more likely to buy stocks that are not very familiar with. And he said this principle gradually became a part of the new conventional wisdom before the Dot Com Bubble.

 

Secondly, he thought that the first comprehensive study of rates of return on common stocks which was completed in 1964 made an impact in the following change of the conventional wisdom of the public. The report showed that an equally weighted stock portfolio have an annual compound return of 9% during 1926 to 1960. Thus people will naturally think the return of the stock exceeds the return of bond over long period. Some of the people at that time even thought the risk in the long run of stock is lower that the bond.

 

The third element is derived from the efficient market hypothesis. This made the investors less likely to notice the fact that the price of the Dot Com companies was probably not right compared to its fundamental. What is interesting is that Richard Thaler, leader of behavioural finance, recriminated to Fama “The only one on the planet reluctant to admit the bubble of NASDAQ stock market in 2000.

 

These three factors, as long as an increasing number of people began to own stocks, made an impact on the stock market. Between 1989 and 1998 the number of individuals in the US who owned stock, either directly, or through mutual funds, or in a self-directed retirement accounts, rose from 42.1 million to 75.8 million, while the number owning stock directly or through mutual funds (but excluding retirement accounts) rose by more than 50% from 31.5 million to 48.5 million. In spite of the changing of the conventional wisdom, according to Brennan, the demise of the defined benefit pension plan also account for it.

 

These further confirmed the idea I have suggested in the former blog that: thought trend of the society changed before bubbles, which is usually an incentive of the formation of the bubble. More insights can be drawn from the book irrational exuberance. Another example is the bubble of Japan which happened at the end of the last century. The Yamato is known for its cautiousness. But what happened to them during the bubble? Because this is not the mainly point of my blog and the reason is very complicated (and still a controversy), I may not talk about it here. In my next blog, I will introduce a speech of Buffett during the Dot Com Bubble and try to give some suggestions to investors.

 

Reference:

Brennan, Michael J. "How did it happen?" Economic Notes 33.1 (2004): 3-22.

 

 

What Caused the Dot Com Bubble: 2: Bubble and Technology Revolution

Technology can be an incentive to the formation of the bubbles. Many of the bubbles were accompanied with the development of the technology revolution. The South Sea Bubble was accompanied with the invention of insurance. And here is the railway mania and the 1929 crash which was accompanied with the invention of cars, radios and airlines. Even the recent crisis and housing bubble was a result of the invention of the new financial technologies.

 

But what makes the development of new technology to be an incentive of the formation of Bubbles? Pástor and Veronesi (2009) thought firms with mainly idiosyncratic risk will initially have high market values, but as the probability of adoption increases, the systematic risk will rise and after the new technology was more widely adapted, it would push up the discount rates and depresses stock prices. But Campbell and Turner (2012) tested whether or not the adoption of railway technology affected the discount rate by comparing the risk and volatility of railway shares with other equity securities. And their results suggested that the direction and timing of changes in these variables are inconsistent with a discount-rate explanation for the Railway Mania.

 

Brennan (2004) also investigated the discount rate in another angle. His research is mainly about the change of the risk premium in the 1990s in US. He found that there is evidence showing the risk premium in capital markets that might have been assessed by sophisticated investors were declining through the 1990’s. And he quoted that Both Claus-Thomas and Ilmanen estimates show a decline in the equity premium in the second half of the 1990’s. And he suggested that it contributed to the movement of the stock price during that time.

 

 

There is a clue to relate the monetary theory with the development of technology during that time. Many policy makers were very optimism about the influence of the development of the technology to the economy. They trust that the growing productivity accompanied with the development of the technology can offset the negative effect of the over eased credit. And thus the prosperity can be prolonged. In fact, Greenspan often quote the work of Paul David that it should take several years for the economy to absorb the benefit produced by the development of the technology. May be he thought that during that time, new technology can manifest itself with the effect of pumping the economy. And what he should do is to ease the credit to fulfill the prosperity.

 

 

 

Reference:

 

Pastor, Lubos, and Pietro Veronesi. Learning in financial markets. No. w14646. National Bureau of Economic Research, 2009.

 

Campbell, G. and Turner, J. D. (2012) “Technological Revolutions, Cash Flows, and Asset Price Reversals: The British Railway Mania”, Queen’s University mimeo.

 

Brennan, Michael J. "How did it happen?" Economic Notes 33.1 (2004): 3-22.

 

What Caused the Dot Com Bubble: 1: Bubble and Deregulation

In 2010, the financial-regulation reform bill has been passed. This made us to rethink the role that financial regulation has played in the formation of dot com bubble.

 

After the great depression, the US economy has developed very well for over 40 years. At that time, the financial regulation was quite strict.

(The Great Depression)

 

After 1970s, the US economy experienced two times of oil crisis, which lead to the high inflation for years. For the purpose of promoting the economy, Reagan-administration gradually deregulated the financial market and therefore it helped the economy to fast develop. Objectively speaking, the financial innovation of the US more or less benefited from the deregulation of that time. But this made people more likely to speculate in the stock market and housing market.

 

In the 1990s, the deregulation has been deepening. And thus from some point of view contributed to the dot com bubble. At that time, investment bank market the shares that they think are of no future. The analysts boast of their outstanding achievement. Many of the stocks they thought to be quite promising are turned out to be not worth a cent. They are duplicity and deceive the investors driven by their private interest. And therefore, the bubble formed. To say the least, the deregulation of the financial market account for the dot com bubble.

 (Greenspan and Ayn Rand)

The financial crisis is also a painful hangover of lacking necessary regulation. The US economy should learn more from an introspection of the dot com bubble but they didn’t. That is partly because the pain from the dot com bubble has been concealed by the stimulation of the aggressive monetary policy.

 

 

 

(The change of the attitude of regulation can also provide a clue about the change of the capital mobility and incidence of banking crisis.)

From next blog, I will talk about the second reason for the dot com bubble-------The technology revolution.

 

What Caused the Dot Com Bubble: 1: US Monetary Policy in 1990's

After the 1970s, the inflation in US had been controlled. Since then, the FED adapted a steady interest rate policy and that seems to be very successful. At the beginning of the 1990s, the US economy slide into depression.  From July 1990 to September 1992, the interest rate of US had been cut for 17 times, from 8% to 3%. This led to the increase of the consumption and investment. And therefore it promoted the development of the economy. From 1994 to 1995, the US economy was overheated. The federal fund rate has been increased for 7 times (ever been regarded as mad) and the economy has softly landed. From 1994, interest policy seems no longer played as an important role as it was used to be.

 

The US economy developed very fast during the late 1990s. The inflation has also been controlled. With the development of the venture capital, high tech corporations developed very fast. From 1998, with the emerging of the overheating of economy, the interest rate has been cut for several times. From June 1999, interest rate has been cut for three times in half a year to prevent the economy from overheating. But it seems that it is not enough. And therefore, interest rate has been increased in February 2, 2000, March 21, 2000, and May 16, 2000. At the end of May, it seems that the economy has been slowed done.  From 2000, to prevent economy from sliding into depression as well as the happening of 9.11, the interest rate has been cut for 11 times. From 6.5% to 1.75%.

 

In September 1996, Greenspan persuaded his colleagues to give up increasing the interest rate. This is partly based on his understanding about productivity and rates of technology progress. In December 5, 1996, he suggested the concept of “irrational exuberance”. The stock market fell and rebounded. In September 29, 1998, three times of interest rate increasing successfully resisted the influence of Asian financial crisis.

 

Evaluation toward the relationship between monetary policy in the 10 years and the dot com bubble should be cautious. But the emerging of the dot com bubble do accompanied with an easy monetary policy and before the burst of it, monetary policy had been tightened.

 

From March 2001, the US economy slide into depression. This is the end of the longest expansion of US economy. Although the bubble was shorter and smaller than we have thought(JB DeLong and K Magin 2006). The depression seems very brief compared with long time of prosperity. So brief was the depression that the way to eliminate it was just like a magic. But after that, the housing bubble follows. And more, the financial crisis follows. Does this explain where the money goes? From John Law’s story, we can get some insights into it.

 

DeLong, J. Bradford, and Konstantin Magin. A short note on the size of the dot-com bubble. No. w12011. National Bureau of Economic Research, 2006.

What Caused the Dot Com Bubble: 1: Money and Economy - Enlightenment From Mississippi Bubble

John Law is “the pleasant character mixture of swindler and prophet.”

------------------Karl Marx

 

 

Yet his swindle has some similarities with contemporary monetary theory?

 

There is much more to talk about the Mississippi Bubble than I have space to explain here. But basically, Law’s idea is that

1: get the right to issue the bank note.

2: Issue the share of his company with the government debt as collateral.

3: The government use the bank note to pay back to the public.

4: The public use the bank note to pay for the share of Law’s company.

 

From the prospective of history, Law is a pioneer. From the strategy above, we can see something similar with the theory of Keynes and Schumpeter. It also reminds me of Krugman’s advice for Japan of 90^th last century which was mainly to say that just print money to pump the economy. The causes of the burst of bubble had been concluded by many researchers. But it is a problem that whether to ask why the bubble burst or to ask why Law’s theory didn’t sustain.

 

Law values paper money. Law’s theory is that in order to make the country rich, money should be utilized. As long as the monetary policy can be flexibility used, prosperity can be achieved. As long as credit can be appropriately adjusted, the economy can be more efficient. Put aside the Mississippi bubble, Law’s theory can win a place in the history of monetary theory. Schumpeter ever praised him as one of the most important monetary theorists. Advanced theory is like the rabbit tied to the tree, run a circle and back to the origin.

 

Law ever controlled all of the financial market, tax and trade of France. Few economists can be as lucky as him in that he can apply his own theory into practice in such large-scale. Although the Mississippi Bubble seems simple and crude in today’s view, but is reveals the essence of bubble: under the stimulation of optimistic expectation, the excessive expansion of credit is likely to stimulate the price of the stock to offset its fundamental. The essential relationship is concealed in modern economy by all kinds of complicated tools and the system itself. But it hasn’t changed too much.

 

What if Law’s theory had been carried out in a more conservative way? What if the state apparatus is more powerful at that time in France? What if Law succeeded in transforming the bubble into a new bubble? What if the incidental incentives that leads to the burst of Mississippi bubble at that time had been put off?

 

All of these give us a new angle in prospecting the dot com bubble (And the financial crisis?).