Morningstar Advisor - February/March 2009 - 46

Morningstar Conversation This asset inflation and credit creation can spiral on the upside and create, for example, a housing boom, as we’ve just seen, or a Nasdaq boom, as we saw in the previous decade. But equally, when they go in the opposite direction, they can spiral in a negative manner and create asset price deflation with credit destruction, as we’re witnessing now. The essence of Minsky’s theory—and I would say Minsky’s theory is really just an extension of Keynes’ theories—is that the financial economy is fundamentally unstable. This is directly opposite to what I would describe as mainstream economic thought, which is that our economic system is fundamentally self-stabilizing. The reason that I find this fascinating, and what is a lot of the topic of my recent book, is that if we examine what the central banks are doing—which is trying to manipulate and control the economy under conventional economic theory—those actions should not be necessary if the economy is self-stabilizing. We have a quite fascinating confusion at the moment in that we have a theory that says the economy is self-stabilizing and we don’t need central banks, but then we have these central banks attempting to stabilize it. Unfortunately, because they are operating to this efficient market theory, the central banks are getting that stabilization process wrong because they’re working to the wrong paradigm. Kaplan: Dr. Ibbotson, is the economy fundamentally unstable or does it self-stabilize? It is curious that economists of every stripe right now are calling for aggressive government action regardless of what theory they seem to normally subscribe to. Ibbotson: The economy has lots of selfstabilizing features, and it has other features that are destabilizing. Most of the time the economy is stabilizing, but certainly, I won’t argue that the situation is stable now; instead, we have discontinuities here of an extreme sort. But there are also behavioral aspects of this. I think the risks are definitely much higher than you might think of just looking at standard deviation, not only from the mathematical aspects of other measures of risk, but also from the way people react when they have the bad result. People often have the bad result at the same time they are losing their human capital income. They’re losing all of their wealth at the same time, so they tend to be much more risk-averse than standard economics would show them to be. There is a lot of risk, and there’s more risk than we think. I agree with both Benoit and George on these points. Kaplan: If you were to receive a phone call from President Obama asking for your advice, what should policy be going forward, both in terms of fiscal policy and monetary policy? Ibbotson: This process is so complicated that I As we recognize that, however, we must recognize that this also represents a failure of previous monetary policy, and that once we have monetized the debt away, we will have to enact a radically different approach to monetary policy—one that pays close attention to credit cycles and not just to managing consumer price inflation. Kaplan: Our readers are getting a lot of questions from their clients about what they should do. What kinds of things should advisors be discussing with their clients? Ibbotson: I would be saying that when markets pull out of calamities, they often have their highest returns. We had the highest return ever in 1933 in the midst of a severe depression. You get the extreme pullout when things start to get a bit better. The markets in general move ahead of what’s actually happening in the economy. The risk premium on stocks has gone way up because of the fact that investors now recognize that there is much more risk in the market than they had recognized. Stocks may not be done dropping, especially in light of what’s happened to the financial system, and I don’t know when it’s going to start to straighten out, but ultimately, in the long run, stocks are a good investment. Cooper: What I would say is that if we look don’t have a ready solution as to how he should organize all these things. There’s not much monetary policy left to be played here because they’ve already cut the rates to near zero. There’s a lot of fiscal policy in Obama’s plan, but I worry about the government being involved too much in the private sector. I think the likelihood of the government being able to straighten out this situation completely is not high; there will be a vast amount of waste in how they spend that money. Putting money into failing companies may be temporarily stabilizing, but it creates long-run problems. Cooper: Well, like Roger Ibbotson, I don’t back through history, yes, we had a crisis in the 1930s, especially in America, and look what happened to America afterwards. America was the most powerful, strongest growing economy for many, many decades. I think if we step back from the financial side of things, and we focus on what really generates wealth for people in the long run, which are technological improvements, we’ll realize that we’re still living through a fantastic environment. Emerging markets are opening up to inward investment and adopting free market principles, allowing investment and allowing human potential to be used more efficiently. I think there’s very good reason to believe that, believe that there is a quick, painless fix available. I think there are different routes that can be taken, but none of them are going to be pain-free. If I were advising President Obama, I would suggest that he acknowledge that we’ve had an excess accumulation of debt and that we now have little choice but to alleviate the burden of that debt through controlled monetization. That is, to inflate away the debt. 46 Morningstar Advisor February/March 2009

Morningstar Advisor - February/March 2009

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