Bennett Group Financial

Unintended Consequences, Deflation, and the Road That's Paved with Good Intentions, by Dawn Bennett


Wasington, DC -- (ReleaseWire) -- 01/26/2015 --This past week brought a host of platitudes to mind. Sayings like "Don't cry over spilled milk," and "A fool and his money are soon parted." But perhaps the most relevant is "The road to hell is paved with good intentions." That really hits home, because it speaks to unintended consequences, which is what we are seeing in the markets, and to the reverse results we're witnessing from Keynesian central bank policies that are negatively affecting so many different layers of not just US markets, but world markets. And despite the fact that the Swiss franc was major news last week, those unintended consequences go far beyond more expensive Swiss chocolate and more expensive Swiss cheese. It goes to another level: we are looking at the beginnings of deflation.

Keynesian economics is a philosophy whose central tenet is that government intervention can stabilize the economy. This philosophy has been informing the actions and policies of the developed economies' central banks for the past six years, and it's led to a world gone upside down where white is black and black is white. These policies are demolishing not only securities markets but currencies, world-wide. The central banks are printing money out of thin air while selling us the Keynesian belief that we must sacrifice the present for the future. We are starting to see the first signs that this "zombie money," is going to disappear back into the thin air from which it was printed, and beginning at the new year, and becoming more evident last week, we can practically watch investment structures in all asset categories begin to shift before our eyes.

A case in point is the dramatic and disruptive surge in the value of the Swiss franc last week. It is important to understand the context, so that we can understand the implications. The Swiss franc has often been considered a good place to put cash in times of uncertainty and volatility, so during the debt crisis in the euro zone, demand for the franc soared, pushing its value up dramatically.

Switzerland's export sector makes up the greater part of the country's GDP, so when a strong franc began to harm exports by making them more expensive to purchasers, the Swiss National Bank (SNB) decided to take action. In September of 2011, the SNB put a peg in the franc's value, essentially printing new francs in order to buy large quantities of euros and other foreign currency. This Keynesian policy worked, for a while. For the remainder of 2011, and through 2014, the SNB's strategy was successful, but there was a hidden time bomb.

That time bomb eventually exploded, of course, because you cannot suppress an asset class indefinitely. Regardless of how good the intentions of the SNB were, once they removed the peg last week the franc shot up in value, causing havoc in the markets. Major FX brokers (foreign currency traders) and hedge funds were essentially wiped out overnight.

So, the SNB was printing money in order to buy currency. At the same time, our own Keynesian central bank, the US Federal Reserve, has been buying US government bonds and futures contracts with its own printed money. Different asset classes, certainly, but with a similar intent: to prop up certain market sectors through direct intervention in the market.

Herbert Stein was an economist who died in 1999. He was a Senior Fellow at the American Enterprise Institute, a contributor to the Wall Street Journal, and chaired the Council of Economic Advisers under presidents Nixon and Ford. He once said something that is particularly poignant and relevant to our current situation. "If something cannot go on forever, it will stop." The question is, what happens when it stops? In Switzerland, the answer is "deflation," and signs point to deflation being a major bugbear in global markets during 2015. China, Europe, the U.S. and Japan are all seeing almost coordinated downtrends in slowing price increases as well as outright price declines.

Deflation kills economies and, eventually societies. Low prices might seem like a good thing at first, but they eventually lead to lower wages, job cuts, and business closures. These are a lethal combination to any economy. Deflation is a sort of parasite living inside the body of the economy, living invisibly for a long time before causing any symptoms of illness. Inevitably, though, it takes over all the organs and weakens and damages its host.

The Keynesian interventions of governments and central banks, world-wide, inevitably lead to unintended consequences. They continue to prop up or suppress oil, currencies, the world stock markets, and because they have essentially infinite money, there is no way to trade against them, to limit the impact of those policies. In the end, though, the consequences always follow. So, something had to give, and oil prices were the first to fall to the deflationary trend. Now we have the Swiss franc as the second instance of fallout. What will be next?

It may be that the US stock markets keep sneezing because Switzerland caught a cold, as they did last week, but it could be Japan next. A recent article in Nikkei Asian Review says that Japan's central bankers are now acknowledging the diminishing returns from their bond buying. "Some in the Bank of Japan are growing anxious about continuing massive purchases of government bonds, confronted with the program's negative side effects. Pressure from the financial industry is strengthening by the day, and all this according to a high ranking official at the Bank of Japan." They continue to say that bond buying has pushed long-term interest rates to unprecedented lows. This has made it impossible for even insurance companies to generate sufficient returns on their investments to pay benefits to their policy holders, so they're going to go through a process of raising premiums on the already broke Japanese. The article concluded that Japan's quantitative easing policies have brought tremendous trouble for the Japanese financial industry, and it's been confirmed by a Bank of Japan official, who was quoted as saying, "I hope we will be able to scale back monetary easing soon by achieving price stability as projected." Will they just stop QE like the SNB did, without warning us, and allow free market forces to create a real recovery?

The talking heads like to say that the US economy is still fundamentally strong, but while there is something to be said for being "the cleanest dirty shirt out there," the economic numbers are proving otherwise. Industrial production numbers for the US were reported last week and they dropped the most in eleven months. Further, last week Bloomberg's US Macro Index, which correlates macro-economic numbers, said that since Thanksgiving our macro-economic numbers are the worst they've been in at least 10 years.

The Swiss did the right thing by removing the peg in the franc's value, but it is causing pain and will continue to do so. Should Japan choose to end quantitative easing, it would also be the right thing, but will expose investors to the true consequences of weak economic fundamentals. The return from a Keynesian, centrally-manipulated market to a true free market will certainly be painful, but it will happen, and it should.

Individual investors must stop listening to the government's lies and distortions and start facing these unintended consequences. They must come up with a plan for self-protection.

Success in investing doesn't necessarily correlate with intelligence. More important is the sort of temperament that allows the investor to avoid acting on the urges and emotional impulses that many people fall prey to, especially in a volatile or precarious market. Anyone can do "easy," anyone can do "good," it's developing and maintaining a strategy for the difficult that truly makes the difference between success and failure.

There are three fundamental mistakes that successful investors avoid. The first is not addressing the market as it is. Just because it was easier in the past to achieve positive returns in the market, does not mean that it is easy today or will be tomorrow. The successful investor doesn't allow a bull market to instill a false sense of confidence. People stick to their guns, and they can stick to their guns all the way down to zero just because it worked for them before. But they're not taking into consideration the changes, the fundamental changes, the technical changes, the fiscal policy changes that are going on not only here in the United States but around the world that are affecting the markets.

The second mistake is holding on to winners as if they will never lose. Many investors form a sort of emotional attachment to their winning investments. This leads them to delay the question, "Is it time to take the profits off the table," often until it is simply too late. While they take their time hugging their special winners to their chests, successful investors have already made a critical evaluation, taken their profits, and are waiting for the best price to jump back in. So the discipline to separate from the emotional attachment that develops when an investment wins over a period of time is crucial to being a winning investor on the whole.

This relates to the third mistake, which is believing that there's a "top" and a "bottom". An investor who always tries to guess the top will eventually lose, and what's more, will stop being an investor and become a gambler instead. And a fact of life for gamblers is that the house always wins in the end. You can outwit or outplay the house every now and then, but the house will take you over the long haul. Instead of trying to guess the top, the successful investor takes it out of the middle, making decisions based not just on the individual investment or the portfolio, but takes the fundamentals, the overall state of the market into account. A good stock picker can certainly find strong possible investments right now, but given the market and the possibility of real upheaval in 2015, it might not be the time to put money into them.

Can the common man and common woman out there win at the market, or is it just the playground of the greedy and the powerful? The individual investor certainly can win, if they can maintain control. Studies show that people often make bad decisions to avoid loss or the possibility of loss. In fact, it seems that the pain of losing is twice as strong as the joy of winning. Discipline and control are the key to minimizing the impact that emotional reactions have on the brain's ability to make rational decisions, and maybe even more importantly, to avoid making mistakes or missing opportunities. This market is only going to magnify the impact of investment decisions rooted in emotional reactions, so it is crucial to develop a clear mindset and strategy.

So, we've been on this Keynesian drug for six years, and withdrawal is going to be tremendous. Be ready.

All data sourced through Bloomberg

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Securities offered through Western International Securities Inc. (WIS), member FINRA/SIPC. BGFS and WIS are separate and unaffiliated entities.

About Dawn Bennett
Dawn Bennett is CEO and Founder of Bennett Group Financial Services. She hosts a national radio program called Financial Myth Busting

She discusses educational topics and events in the financial news, along with her thoughts on the economy, financial markets, investments, and more with her live guests, who have included rock legend Ted Nugent, as well as Steve Forbes and Grover Norquist. Listeners can call 855-884-DAWN a as well as take podcasts on the road and forums for interaction.

She can be reached on Twitter @DawnBennettFMB or on Facebook Financial Myth Busting with Dawn Bennett or