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Sunday, December 27, 2009

Government actions to rescue the economy actually threaten the economy

This experience in Yellowstone sounds a lot like what’s happening in our economy today. Congress and the Federal Reserve are so busy “rescuing” specific pieces of the economy that they fail to realize how these efforts are threatening other pieces of the economy.

Our government has propped up the auto manufacturers. It’s propped up numerous banks, mortgage lenders and the world’s biggest insurer, AIG. But the rest of the economy is still swooning.

In fact, portions of the government’s rescue efforts are contributing to the economy’s difficulties. Because the Fed is supplying so much credit at such low rates of interest to the big finance companies, these finance companies can make a lot of money by simply buying Treasuries, rather then lending to businesses. The result is that most small and mid-sized companies cannot get loans. If the Fed’s did not supply credit so inexpensively, the banks would be forced to loan to businesses.

Unintended effects like this one produce unintended effects elsewhere, and before you know it, cause and effect are hard to discern…or to explain accurately. “Yet our minds are not beyond making up a cause to relieve the itch of an unexplained effect,” Mauboussin writes. “When a mind seeking links between cause and effect meets a system that conceals them, accidents will happen.”

That’s why so many so-called experts are so often dead wrong. They think that know what’s causing what. But they don’t.

For instance, there is no shortage of financial experts who will tell their clients to put 15% of their portfolio here and 10% there or whatever. And these experts will have definite opinions on each of their recommended mutual funds. This one is better than that one. They’ll give numbers. It will seem very concrete and real and “expert.”

But guess what? Almost all the experts produced an identical 35% loss for their clients in 2008.

If an investor hopes to minimize or avoid losses of this magnitude, they must understand that economies are complex adaptive systems – replete with feedback loops and black swans and power laws. Investors must approach the future with humility. And that means fearing risk more than craving reward. A humble investor will also insist on a margin of safety in each investment.
-- from "The Yellowstone Syndrome" by Chris Mayer.

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