Peter Bernstein’s biggest worry? The dollar

An interesting interview with Peter Bernstein, author of Against the Gods: The Remarkable Story of Risk.  Though from a conference back in June, this was published in last month’s issue of CFAI’s Conference Proceedings Quarterly.  Every bit as relevant today as it was then.  See the second question/answer for Bernstein’s biggest worry: the dollar.  I suspect he hasn’t changed his mind since June.

Question:   Has the Fed over-stepped its boundaries with the bailouts of Long-Term Capital Management and Bear Stearns?

Bernstein:   This is a controversial question and an extremely important one. The questions really are (1) do we let the market take its course, believing that the market knows more than the regulators, or (2) do the regulators have a responsibility to make decisions for the market? The view that says the market needs to solve these problems itself goes back to Schumpeter.  His view was that every now and then, business needs to have a cold shower. In other words, we should let nature take its course. I don’t agree with Schumpeter’s position. At one time, possibly, I could have agreed, but I think the world has advanced too far.  If the Fed had held back from creating liquidity to support the system while waiting to see what would happen, it would have produced a catastrophe because of the structure that has developed, the layers of debt, and the interconnectivity existing today on a worldwide basis. In addition, there is simply too much debt in the system. But trying to reduce that debt quickly would bring down the whole system. I think Bernanke is conscious of the problems as well as sensitive to the criticism of Greenspan, who thought we had to protect the economy from an accumulative decline. Bernanke has handled the current crisis with sensitivity, understanding, and full awareness of the dangers in all directions.

Rolfe here.  The problem with this answer is that it isn’t one.  As as has been argued here previously, Schumpeter was right: creative destruction is necessary for a capitalist economy to thrive.  The business cycle can’t be inflated into extinction.  In attempting that during his years at the Fed, Greenspan allowed financials to grow too large.  Now they have to fail, but they can’t be allowed to.  In Bernstein’s words: there’s too much debt, but reducing it “quickly” will “bring down the whole system.”  Presumably the only solution is to bring it down slowly.  That may just happen if we’re lucky.

My personal belief is we won’t be lucky.  The stupendous growth of U.S. liabilities, via bailouts and the Fed’s growing balance sheet, could very well lead to a large fall in the value of the dollar.  A view Bernstein appears to share…

Question:   What do you see as the big risks today?

Bernstein:   What worries me the most is the U.S. dollar.

The most powerful idea that shapes my life, both professionally and personally, is Pascal’s wager. Pascal was the man who invented how to calculate probability, a momentous discovery because it was the first time in human history that we had a way of thinking systematically about the future. But the importance of Pascal’s wager does not lie in the calculation of probabilities. Rather, it demonstrates that the consequences of being wrong about the future are more important than the probabilities themselves.

[A quick summary:  Pascal's wager was a bet on the existence of God.  "What have you got to lose?" was the French philosopher's argument.  If you're right, you go to heaven.  If you're wrong, you're dead anyway.]

The source of our current problems was the mass failure to consider the consequences of being wrong about the assumption that house prices only go up.  For the same reason, I worry about the dollar. I don’t know what the probabilities are of a dollar collapse; some days I think they are large, and some days I think they are small. But all the necessary conditions for a  catastrophe with the dollar are in place because of the enormous liquid liabilities to foreigners that now exist.

A crisis with the dollar could be the greatest risk we face. Other risks can be dealt with, but if the dollar ceases to be a currency that people want to hold, the only way to deal with it domestically would be to raise interest rates—by a lot.  The probability of that occurring is small because so many people have a vested interest in avoiding it, but the consequences would be disastrous if it becomes unavoidable.  As we move forward, there are a few signs suggesting a dollar crisis is less avoidable than it was a few years ago. I think we must hedge the risk of the dollar failing because the consequences are so serious, regardless of the probabilities.

Sounds a bit like Dick Cheney’s 1% Doctrine, though I think the probability of a dollar collapse is probably 10x higher.  If I could ask Bernstein a follow up it would be how he would “hedge the risk of dollar failure” while simultaneously acting to support the banking system.  The actions to achieve the latter, easy money by the Fed + infinite bailouts from the Treasury, could very well precipitate the former.

Question:   Will inflation pressure persist, and if so, what portfolio adjustments would you suggest?

Bernstein:   This is the big question. My head says yes, my gut tells me no. I believe in the price system, and I think a slowdown in business activity will tend to diminish inflationary pressures.  But in a long-term view, the problem of more demand than supply in oil and other commodities is not going away.  I do not think anybody realized what would happen when the economies of countries such as China, India, and Brazil began growing and that their growth would attain such magnitude.  Nor did people realize that finding enough resources to meet demand was going to require so much time and be so expensive until we can develop substitutes.  Long-term inflation is a real problem, and unfortunately, we cannot do much about it except try to live with it.

He was certainly correct that the slowdown in business activity would reduce inflationary pressures.  See oil’s fall from $145 to $40.  I think he is also right that, long-term, inflation is a problem we will have to learn to live with.

Posted in Dollar, Fed, Interest Rates, bailout, banking, credit crunch, debt, inflation |