Who's Got the Power?
By Doug Wakefield with Ben Hill
The following is the first five pages of our July newsletter. The entire newsletter is offered at no cost to those who subscribe through our website.
"When the guardians of the public financial mores begin urging people to acts of recklessness, we cannot help but notice. Buy more, says one Fed governor. Borrow more, says another. Don't worry about debt, interest rates, or the loss of jobs, says the captain of them all. It is as though the National Council of Bishops had come out with a public statement urging wife swapping." 1
I realize this quote may seem a bit vulgar, but sometimes plain, yet unrecognized, truths must be stated in such a way if only to shake us from the lethargy of prevailing error, and to help us grasp the paradox, and perhaps the gravity, of the situation. Many continue to argue that the Fed is the ultimate (or efficient) cause of inflation, and on the surface this seems to make sense. Yet, deeper study shows that the Fed, in the sense spoken of above, is a gatekeeper. They can open and shut the gate that gives access to credit, which drives inflation, and even entice individuals to partake, but they cannot force people to consume credit.
Last month we presented two historic examples of when the Fed and the Bank of Japan were unable to thwart deflation. Still, bulls and bears alike assume that the Fed has the ability to create inflation whenever it feels the whim to do so. This line of thinking is so replete that it borders on a social phenomenon. Those "foolish" enough to question this "fact" are patronized with chiding explanations on the subject. And, of course, this got me to thinking.
The basis of contrarian investing is that the majority is usually wrong. The majority, also known as society, exerts such an incredible pull on us that I am amazed that any of us can partially stand outside of its influence for a moment. Whether we call it peer pressure, crowd psychology, groupthink, or sociology, we have innate tendencies to act collectively. Conscious awareness of these tendencies often goes unnoticed. Without this awareness our ability to think and act independently is greatly diminished.
Is the suggestion that the Fed, and monetary policy, has limitations so far outside of the realm of possibilities - especially when history and science have shown that this is the case? Then why does our society hold so dogmatically to the belief that the Fed can control the world? In 1841, Charles Mackay said the following:
"Every age has its peculiar folly; some scheme, project, or phantasy into which it plunges, spurred on by the love of gain, the necessity of excitement, or the mere force of imitation." 2
But, certainly we are too sophisticated for this statement to hold true today. Or, is our overconfidence in our sophistication the sophistry, which will prove to be our Achilles' heel? However we choose to answer that question, we cannot deny that crowd behavior does affect each and every one of us. It is not the Fed, but society, which has the power.
In this newsletter we will show that societal pressures exert a strong pull on all of us, that because of the timeframes over which they occur, we are largely unaware of the extent of the changes in our society, and that the increasing complexity within our society has reached a point of unsustainability.
With So Many People Thinking Otherwise, Who Are You to Disagree?
Herding... It is one of the most powerful forces in our lives, and, at least to some extent, its power is in its subtlety. While most individuals reading this newsletter are somewhat familiar with this concept, those who will go further, and actually study it and grasp the essence of this idea, are likely to realize that this not only affects the way that we view markets, but it also changes the way that we think about a great many things in our lives.
We often read about the contrarian investor who stood outside the crowd and whose fortitude paid off. We respect their poise, but our interaction with these stories ends there. We are unable to apply the lesson. When we look at the forces of herding, we begin to understand why.
Robert Prechter's book, The Wave Principle of Human Social Behavior, provides a broad understanding of our herding instincts from psychological and sociological standpoints. Here, Prechter discusses one aspect of our unconscious societal tendencies. As you read these words, think about whether or not you have witnessed such behaviors in your own life.
"Falling into line with others for self-preservation involves not only the pursuit of positive values but also avoidance of negative values, in which case the emotions reinforcing herding behavior are even stronger. Reptiles and birds harass strangers. A flock of poultry will peck to death any individual bird that has wounds or blemishes. Likewise, humans can be a threat to each other if there are perceived differences between them. It is an advantage to survival, then, to avoid rejection by revealing your sameness." (Italics his) 3
But, herding is not limited to survival situations. Dr. Irving Janis, professor of psychology at Yale University, corroborates from his studies of group decision-making.
"'In general, the greater the number of those in the decision maker's social network who are aware of the decision, the more powerful the incentive to avoid the social disapproval that might result from a reversal.' What's more, 'The greater the commitment to a prior decision, the greater the anticipated utilitarian losses, social disapproval and self-disapproval from failing to continue the present course of action and hence a greater degree of stress.'" (Italics his) 4
In speaking of the disastrous decisions that some societies make, Dr. Jared Diamond, Pulitzer Prize winner and professor of geography at UCLA, substantiates the herding concept from his field of study.
"One possible reason for irrational refusal to try to solve a perceived problem is a well-recognized phenomenon in short-term decision-making termed 'crowd psychology.' Individuals who find themselves members of a large coherent group or crowd, especially one that is emotionally excited, may become swept along to support the group's decision, even though the same individuals might have rejected the decision if allowed to reflect on it alone at leisure. As the German dramatist Schiller wrote, 'Anyone taken as an individual is tolerably sensible and reasonable - as a member of a crowd, he at once becomes a blockhead.'" 5
The very reason that a contrarian view is sometimes considered "extremist" or "alarmist" is the same reason that CEOs and politicians are sometimes held in high esteem. As John Nofsinger, Associate Professor of Finance at Washington State University explains below, peoples' perceptions have a great deal to do with the prevailing social mood.
"Social mood determines the general attitude toward business and businesspeople. When social mood is high, corporate CEOs are treated like heroes and business is considered one of the most sacred and important institutions in society. When social mood is low, executives are considered greedy and companies are believed to be cheating the public. During periods of low social mood, these attitudes lead to more government intervention into business. Governments may become more active in antitrust activities and enact more regulations when social mood is declining. During optimistic times, however, the government may allow more mergers and deregulate industries." 6
Governments, by the very nature of bureaucracy, represent group thinking. As such, their actions are often the best examples of herd behavior. Since the historical record has many such examples on both sides of the isle, this is not intended to be a criticism of a particular person or party, but rather, an observation of the fact that people herd and that the majority is often wrong. A great example of this can be seen in the events that surrounded the establishment and repeal of the Glass-Steagall Act.
In 1933, the Glass-Steagall Act (GSA) was enacted, which set up a wall separating commercial and investment banking activities. The Dow had (already) crashed. This, combined with the conditions of the Great Depression, had a profound effect on investors and our society as a whole. The United States was experiencing a great deal of negativity on many fronts, and the securities and banking industry was no exception. The government "had to do something," so the Glass-Steagall Act was put in place.
Now, let's fast-forward to November of 1999, when the Glass-Steagall Act was repealed. The line of reasoning given for the revocation of this act and the timeframe of its annulment, combine to show how social mood, reflected in legislation, exercises control over the government's decisions. Investopedia notes the following:
"The limitations of the GSA [Glass-Steagall Act] on the banking sector sparked a debate over how much restriction is healthy for the industry. Many argued that allowing banks to diversify in moderation offers the banking industry the potential to reduce risk, so the restrictions of the GSA could have actually had an adverse effect, making the banking industry riskier rather than safer. Furthermore, big banks of the post-Enron market are likely to be more transparent, thus lessening the possibility of assuming too much risk or masking unsound investment decisions. As such, reputation has come to mean everything in today's market, and that could be enough to motivate banks to regulate themselves.
Although the barrier between commercial and investment banking aimed to prevent a loss of deposits in the event of investment failures, the reasons for the repeal of the GSA show that even regulatory attempts for safety can have adverse effects." 7 (Italics mine)
As we can see, groups wield a great deal of influence over the actions and thoughts of individuals and, as evidenced here and in our other writings, groups often do the wrong thing at the wrong time. Though most of us realize that we are at least somewhat affected by societal pressures, we often overestimate our independence and doubt that we would follow any crowd into some great folly. Yet, the reason that we are often swept along with the crowd is that the rate of change is slow enough that we perceive each subsequent change as being within the realm of normalcy.
To read the entire July Newsletter, you can sign up, at no cost, through our website. If you would like a copy of our research paper, Riders on the Storm: Short Selling in Contrary Winds, visit our website. This will also give you access to archives of the same monthly newsletter titled, The Investors Mind: Anticipating Trends through the Lens of History.
1. Empire of Debt: The Rise of an Epic Financial Crisis (2006), Bill Bonner & Addison Wiggin, page 255
2. Memoirs of Extraordinary Popular Delusions, Volume Two (2004), Charles MacKay, page 2
3. The Wave Principle of Human Social Behavior and the New Science of Socionomics (1999), Robert Prechter, page 156
5. Collapse: How Societies Choose to Fail or Succeed (2005), Jared Diamond, page 435
6. The Journal of Behavioral Finance, Volume 6, Number 3 (2005), "Social Mood and Financial Economics", John R. Nofsinger, page 147