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October 13, 2004

Government Gifts & Monty Hall Paradox
by Richard Benson

Years ago there was a controversy with respect to a game show where the host offers you the opportunity to win what is behind one of three doors. Typically there was a really nice prize (i.e. a car) behind one of the doors and a not-so-nice prize (i.e. a goat) behind the other two. After selecting a door, the host would then proceed to open one of the doors you didn't select. It is important to note that the host would NOT open the door that concealed the car. At this point, he would then ask you if you wanted to switch to the other door before revealing what you had won.

Apparently, in response to a newspaper column written about the show, a reader posed the following question: "Is it to your advantage to take the switch?"

This problem was given the name The Monty Hall Paradox in honor of the long time host of the television game show "Let's Make a Deal." The reporter's answer to the reader was that the contestant should switch doors and she received nearly 10,000 responses from readers, most of them disagreeing with her. Several were from mathematicians and scientists whose responses ranged from hostility to disappointment at the nation's lack of mathematical skills.

In the real world, of course, the Monty Hall Paradox is even worse because while behind one door there is nothing, and behind another door there is a nice prize, behind the final door is an absolute ogre who will devour both you and your investments.

If our nation's lack of mathematical skills were evident back then, why should it not surprise us that behind today's Door #1, Gift Giving by the Government, it's hard to resist as policy even though the "gift" comes from taxpayer money. An example would be when the government pays farmers not to grow crops and the farmers choose to take the government gift (in the form of a farm subsidy) rather than plant or harvest. Farm Subsidies, Tax Rebates and FEMA Aid are examples of small government gifts paid for by you and me, the taxpayers, with, of course, our own money.

However, the really big money gifts, behind Door #2, are handed out by the world's central banks. In the financial markets, this money is gifted to those participants who are bright enough to take it when it is offered (savvy investors don't bother to listen to Wall Street in its relentless efforts to get people to buy stocks and bonds at inflated prices). With this really big money behind Door #2, individual investors should take the money, lock Door #3, and run for their lives. In other words, selling your stock and bond portfolios and getting out is a wise thing to do. Opening Door #3 is what will happen when the foreign central banks stop buying dollar denominated assets. Behind that door is a crash, not a gift. As a prudent investor, opening the right door is as vitally important as not opening the wrong door.

It's a fact that in order to keep the United States' economy moving, the Federal Reserve has cut short-term interest rates to 46-year lows. In order to facilitate the continued buying by American consumers of imports, Asian central banks have financed most of our country's budget deficit. These foreign central banks have subsidized the dollar to keep it stronger and lowered our longer term interest rates, making sure that our country's budget deficit caused no pain. Normally, a $450+ billion U.S. Treasury deficit - for a country like America that has no savings - would have sucked all the liquidity out of the money market and forced up longer term interest rates. But this hasn't happened. Why?

Over the past few years, foreign central banks have spent $700 billion to keep the dollar strong and our interest rates low. (The foreign central bank subsidy - to the dollar and U.S. interest rates - now totals over $1.3 Trillion). This foreign central bank gift is targeted directly at the financial markets, causing a stronger than deserved dollar and much lower than justified market interest rates. Major corporations and institutional investors, like Warren Buffet, have used the central bank gift as an opportunity to take massive short positions on the dollar. Moreover, major corporations have remained active borrowers in the bond market at current subsidized interest rates and built up strong liquidity positions.

Serious professional investors understand that if the cost of borrowing is subsidized, the subsidy goes to those who borrow. (Since the way corporations borrow is to sell bonds, selling bonds looks like the smart thing to do.) Because interest rates have been subsidized down, bond prices are artificially pushed up, and if bond prices are artificially high, it is certain that stock prices are also inflated.

Clearly, the subsidies to the financial markets are so big this just can't go on forever. Savers in America are paying a horrible price by receiving inadequate yields on their savings and over-paying for stocks and bonds. In China, the dollar subsidy is causing unwanted inflation and robbing the Chinese consumer.

When it comes to the timing on selling your gift to get the maximum benefit, it would be nice to know when the subsidies will end. A telltale sign of this beginning to happen would be the recent rise in short-term interest rates with more rate increases to come by an accommodative Fed. The Fed's gifts are slowly being removed ¼% at a time. The foreign central bank gifts for the dollar and interest rates will disappear when the world recognizes that America's trade deficit is an international threat and the dollar must be devalued.

Ah, life was indeed much simpler when investing offered a prize behind a door, and no loss behind the other two doors. Today, your Monty Hall choices are: Door #1 - Stocks and Bonds that will give you a big loss; Door #2 - Cash which looks like it won't give you a loss but actually will, as the dollar devalues, and Door #3 - Foreign currency, precious metals and short positions in bonds and stocks that can offer large gains.

Listen to Monty Hall but watch the activity of the world's central banks carefully before contemplating which door to pick.

Richard Benson
Benson's Economic & Market Trends
Specialty Finance Group, LLC

Prior to founding the Specialty Finance Group in 1989, Mr. Benson acted as a trading desk economist for Chase Manhattan Bank in the early 1980's and started in the securitization business in 1983 at Bear Stearns, and helped build the early securitization businesses at Citibank and E.F. Hutton.

Mr. Benson graduated from the University of Wisconsin in 1970 in the Honors Program in Math, and did his doctoral work in Economics at Harvard University. Mr. Benson is a member of the Harvard Club of New York and Palm Beach.

The Specialty Finance Group, LLC is a Florida Limited Liability Company and is registered with the NASD/SIPC as a Broker/Dealer.

Copyright © 2004-2008 Richard Benson

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