Accurate Delusions About Current Risks
"There are three kinds of lies: Lies, damn lies, and statistics." - Benjamin Disraeli (1804-1881)
We have our favorite statistics reports - among them the Federal Reserve's Flow of Funds Accounts of the United States (Z1) and the Bank of International Settlements' BIS Quarterly Review: International Banking and Financial Developments. Both are issued quarterly (the latest editions released this past month) and each carry over 100 pages of dense, statistical tables. We like to analyze these in detail. They are invaluable as they provide statistics that apply to the real world of money and credit-the actual money flows revealing the impact of market values as well as raw, non-adjusted data that is relatively free of "spin." That's a precious benefit to analysts who like to base their perspectives upon theory and causality ... unlike the "marketing-driven" spin of much of Wall Street's financial prognosticators.
Yet, for all the probity of the two above-mentioned reports, their recent trove of data paints the "reality of a fairy tale." That phrase may sound like an oxymoron. But, no it isn't. We read the relatively-trusted numbers of each of these reports (reality) but they nevertheless depict a fantasy that has been steadily but incredulously evolving this past half decade. One likely wouldn't know this phantasmological story from mainstream reporting.
Consider just three sample "realities" that we discern from these latest reports:
Total US credit market debt, both financial and non-financial, has expanded 40.4% and 48.9% since the end of 2000, respectively. In the meantime, over this same period nominal national income has risen 24.4%, roughly half the rate of total debt increases. Remarkably, many insist that these developments are the basis for a robust, riskfree future. To them, more of the same is the sinecure for a solid retirement portfolio.
According to the BIS, more international debt has been issued in the third millennium this far (BIS Table A85 which carries statistics up to June 30, 2005) than in the entirety of human financial history that has gone before. The total outstanding stock of these international debt instruments (exclusive of domestic bonds) figured in US dollars more than doubled to a total of $14 trillion USD between end- 2000 and June 30, 2005 ... a period of only 4½ years!
Taking a global perspective of the rapid build-up of tradable financial assets, please take a look at Figure 1. It shows the world-wide boom in the position value of stocks and bonds as well as the notional value of derivatives instruments. While we are mixing apples and oranges here in some respects, we sum these three to show the blazing trend in "financial position value" in recent years. Fantastically, while the average income of everyone on the planet between 1982 to 2004 (according to the World Bank) has risen from $2,147 per capita to approximately $6,440, (USD current) the total "financial position value" has risen from $1,920 per capita to $61,443 by the end of December 2004, almost 10X underlying annual income. We've taken the license to plug in a few estimates of our own in order to fill in some of the holes in the available date. Our estimates only serve to better capture the reality of the fairy tale, not to exaggerate it. Is the trend that Figure I shows sustainable? Only if everyone in the world becomes a trader or broker.
Statistics: Make Your Own Reality
We could cite hundreds of statistics that should be noteworthy to sensible investors and policymakers. But, rather than provide any detailed examination of the underlying underpinnings to this emerging fairy tale, we want to instead focus on the deceptive role of statistics themselves. Doing so, we make a few simple points.
There are stupendous developments underway currently which are past the point of believability, yet they are occurring but not widely believed nor disseminated. Worse, many financial economists and strategists continue to behave as if these trends are sustainable and ultimately non-threatening to investors. Even if perhaps not in deliberate denial, they choose to ignore the simple but unsustainable realities that these reliable statistics belie. Instead, what is popularly interpreted is the case for a continuing "blue sky" scenario - to stay fully invested, in other words - that risks are low, all based on the warped perceptions taken from these and other "headline" statistics. And that's our send-off point for an examination of the statistical chicanery that exists at present in much of the financial world. It will do no harm if investors were to take note of the present deceptive condition of statistics and the straight "lies" that they can tell.
The Rule of Perceptions
We read statistics every day. The papers are full of them, TV commercial throw them at us, and the purveyors of investment services literally bury us in them. Absolutely everything - from happiness to donuts - is quoted in terms of statistics of monetary equivalents. Hopefully, the immediate questions will be these: Just how were these estimates made? What techniques could possibly have been used to convert unrelated phenomena to a common language of money? After all, the practice of relating facts to monetary value can be crude and inappropriate. For example, what's the value of a liver transplant? What's the real, monetary value of reality? These are difficult questions. The answers are unquantifiable. Yet, statistical monetary equivalents like these are estimated and printed daily about almost everything and anything.
It wasn't always this way. What happened? It reveals the common language of our time - the numbers of money. Everybody speaks it; almost everybody allows reality to be painted by its perceptions. The problem is that it is mostly a faulty language removed from facts and reality.
Numbers shape and form statistics. That allows statistics to be considered as the representatives of reality and truth. But what if numbers lie? Therefore, we are more interested in the application of numbers; how they are interpreted; their influence upon beliefs.
Talking Numerically is Believable
Numeracy - the practice of documenting news, opinions and trends with numbers - is highly valued. News reporters and researchers practice it liberally. If we did not exhibit some numeracy in writing these reports-peppering pages with many statistics and footnotes-you, the reader, would surely find our views less credible. If we didn't document trends by expressing various changes over a given period in terms of percentages, or by counting the growth or decline in the units of something, and referencing this information to reputable sources, you would be less able to assess the validity of our conclusions. Numeracy is very useful ... used in good measure.
Yet, an excessive fixation with numeracy, can lead to some dangers - ones that are extremely hazardous to investors and savers and their understanding of the real foundations of the current economic climate. How can numeracy - something that is innately useful - lead to peril? It serves as the springboard for three negative developments to which most everybody is susceptible: 1. As a mechanism for widespread deception and misinformation; 2. As a bridge to a world totally defined in terms of the single dimension of money; and lastly; 3. To a world which chooses to accept numerical systems and mathematical theories as the only basis for causality. It seems the everchanging motives of humanity have been left out of the equation.
A hyped monetary numeracy has happened in several stages. It first begins in a fixation with quantification. Every trend and development is expressed in numerical terms, documented and captured in a statistical quantification. That in itself is not overly worrisome. Where the danger really lies is in the fact that our focus moves from the real - the actual thing that is happening or being documented - to the statistic itself. The statistic now serves as numerical image of the thing that is being quantified. Just how accurate is this picture? Can numbers really capture all of the nuances of something that is real? Three apples on a table may be exactly that. But what does it mean that the annualized rate of inflation has fallen to 2.0% over the past month? Or, what is implied by the statistic that the teenage birth rate is declining by some percentage from the year before? These types of statistic require a more sophisticated interpretation. The image that these types of numbers portray can rarely be accepted for their face value. More often than not, the real truth lies underneath this neat veneer of statistical precision. Though the numbers themselves are accurate, the truth can be very different from what seems obvious from the statistical headline.
To illustrate, let's briefly examine the statistic about inflation. What does it really mean that inflation has fallen to 2.0%? To know, first requires an understanding about what inflation really is. Very few people really do. Alarmingly, very few financial professionals do either. Most accept the convenient and sanitized statistic of the Consumer Price Index (CPI) that is issued by the US Bureau of Economic Analysis (BEA) for its face value. The same applies to similar measures reported by other national statistics agencies around the world. As it happens, real inflation is actually something very different. The CPI has been grossly misrepresented real inflation trends these past decades. Yet, the CPI statistic is followed slavishly. It's accepted as truth. As a result, people can (and are) being misled.
We could cite many more examples. What George Orwell said about words has now happened to numbers. In 1946, in an article called Politics and the English Language, he decried the deliberate misuse of words, writing that people craft their words "to make lies sound truthful and murder respectable and to give an appearance of solidity to pure wind." That's what has happened to the world of popular statistics ... certainly economic data.
Numeracy itself isn't the danger. The danger is in blindly accepting numbers as the image of reality and fact with no further critical analysis. That's the vulnerability of our time of instant analysis and computer-driven trading - allowing statistical numbers to reign as reality and fact. It's very easy to allow this to happen. We live in an industry bombarded by data, virtually drowning in a flood of numbers and informational overload. There is too little time for critical analysis and too many statistics ... and a performance target to meet. It's easier to accept the "sound bites" of the statistics just as they appear. What they seem to mean becomes perception.
Surely only neophyte investors and analysts are vulnerable to such mistakes. If that were the case, statistical abuse wouldn't be so much of a problem. The reality is that it also applies to professional people as well - the very same people who are more inclined to work with and depend upon numbers and statistics. In our experience, few of them critically examined the true underlying realities hidden under numbers and statistics. Little critical analysis takes place on Wall Street, not even among its financial analysts and economists.
For example, very few economists actually understand how many statistics are calculated and derived in the first place. Even fewer understand the causes and effects that drive the trends behind these statistics ... the causal economic theories. This is not an unfounded judgment. For the most part, professionals simply do not have the time to do real research or to diligently examine the real facts behind the numbers. A few of them do ... but far too few to make much difference. It's much easier to accept the number for its face value. Knowledge of the statistic itself passes for understanding.
What has happened then is that perception has become reality. The statistical number portrays the image that is perceived. Therefore, this number has power because it can form and change popular perceptions. Actual reality therefore becomes inconsequential. Even worse, the fact of the matter becomes a liability if it is different from perception. Were we to take the time to examine a statistic and discover that its true meaning is very different than perception, it wouldn't be very helpful. Why? Because almost everyone else will have accepted its face-value appearance for fact.
Let's assume that the just released economic statistic shows that the inflation level has declined, though real monetary inflation in fact is increasing. The majority of portfolio managers and investors will be sure to greet it as a positive development, perhaps quickly jumping into the market with new buy orders. The stock and bond markets lurch upward. The facts didn't matter; perception did. Those that acted on the real facts lost out for the time being..
Perception passes for reality. Benjamin Disraeli's famous quip (see the first page) strikes to the heart of a serious issue. If perceptions are allowed to rule with careless reference to facts, truth and reality, then statistics become very powerful. Now, they can hide more than they reveal. And if that's the case, then why wouldn't they be manipulated in order to create a certain desired perception? It's an important step in the creation of manic financial bubbles, and in separating reason from emotional impulses. It's a condition that applies right now.
Are statistics deliberately manipulated? At times, very definitely. But, if that sounds like the stuff of conspiracies, it isn't. It's just human nature at work. Consider these two classics of statistical tampering, pulled from our clipping files and past letters:
As of November 1991, the US Department of Commerce decided to switch its reporting on economic growth to the measure of Gross Domestic Product (GDP) from Gross National Product (GNP). There is a significance between the two that might not have been noticed by most. Roughly explained, the former does not include earnings from foreign sources, while the latter does. Since America is running large deficits with the rest of the world, GDP will appear bigger than GNP. This statistical slight of hand can boost reported growth by over 1% in some quarters.
In Britain, few economic statistics have been more mistrusted than the government's measure of unemployment. Between 1979 and 1995, some 30 adjustments have been made to the way that this statistic is calculated. Apparently, in violation of the law of averages, 29 of these caused "unemployment" to fall.
We could recount many more examples. Isn't it strange that the definition of these statistics tends to only change in one direction - any which way that leads towards a more favorable perception. And invariably, what's favorable is any change that seems to be positive for gain and the perception of economic well-being. Is there a diabolical conspiracy behind the above-mentioned statistical shifts? Yes, in a way there is, but not necessarily in the sense that there is a great, organized scheme underway on the part of the government to delude the public. It illustrates just one of the subtle orchestrations that's part of human nature.
But numeracy and numbers can lead to even worse abuses. Not only can they make us vulnerable to deceit and manipulation, they set up an all-important interface that allows the force of greed to wreak corruption and ultimate impoverishment. For instance, the monetary equivalents of stock indices, housing prices ... etc. all appear to give the impression that wealth and financial well-being is rising. Yes, for some. But for broader society, a process of impoverishment is steadily underway. Don't believe it? Look at Figure 2 (page 3.) A chart showing housing prices divided by labor income looks even much worse.
Our Final Perceptions
Here are some final thoughts for contemplation. We seem to be experiencing a time with more statistics and data than ever before, but less certifiable facts and knowledge. People seem to know the price of everything, but few the value of anything. We live in a financial era where prices abound without values; and costs are only measured in prices. In such a world the price becomes the value and values are separated from real costs. What that means is that the common denominator of what is always best becomes the price ... a rising one preferably.
We encounter countless statistics virtually by the minute in our research. What alarms us is that so many of them can be very misleading, giving rise to little more than ill-informed perceptions. We think it is remarkable how little many professionals actually know about how various statistics are complied or derived. It should be mandatory rule that every economist or strategist read the guidebooks that are available for the National Income and Production Accounts, and other statistical works. We have always had copies of such guides in our offices, whenever available.
While we may have waxed somewhat philosophical in this issue of the Global Spin™, it nevertheless partly illustrates why we have embarked upon a cautious course for all the portfolios under our stewardship over the past year. We have been responding to heightening risks ... and our interpretations of the fairy tale "statistics." These may not be as popularly perceived, but to us the facts say that the risks are presently high and real.
1. Financial Times December 5, 1996.
2. Economist September 21, 1991.