Europa Endlos

One exercise that I used to do quite often, back in the days when I was a "professional" trader (that is to say, a trader with other people's money), was to make up improbable scenarios and justify / explain them.

Part of my motivation for this exercise was to be intentionally and deliberately contrarian. Saying No when the market says Yes is a long-term profitable strategy in itself, irrespective of the underlying fundamentals. (Some day I will write a longer post on why this should be the case).

Another part of my motivation was to have fun. There's nothing like donning a tin-foil hat to enliven a drab afternoon trading session.

But the most important part of my motivation was a serious one: to avoid confirmation bias. Quoting Wikipedia: "Confirmation bias is the tendency for people to favor information that confirms their preconceptions or hypotheses, regardless of whether the information is true."

This was something I had to constantly guard against in my career as a trader. Given the sheer volume of market data that I was constantly barraged by, and the necessity of somehow filtering that data, it was essential to make sure that my filters were unbiased. Considering alternative points of view not tainted by a priori estimates of "probability" was an excellent way of maintaining filter neutrality. Hence the contrarian game.

Here's an example of how to play. Right now the newspapers are full of the Irish bailout and the fear of contagion in other Eurozone economies ("PIIGS-hooey"). You might think that this somewhat fraught state of affairs would lead to a decline in the Euro, and indeed that is the consensus opinion. So your task is to be contrarian and invent a rationale for going long the Euro, despite (or perhaps because of) these macro currents.

And here's such a rationale. Assume the crisis gets worse. Assume contagion in the form of inexorably rising bond yields spreads to Portugal, then Spain, then Italy. The worse the crisis gets, the less possible it is for the centre to bail out the periphery. The only option left is default, and possibly exit. But what happens after that? As successive dominoes fall, the common currency zone shrinks until only healthy core countries (read: Germany) remain. The Euro ends up looking a lot like the old Deutsche Mark. Freed of all its baggage, it begins to rally. Voila!

Note that I don't actually believe this scenario will eventuate, at least not with a high probability and not in the near term. But at the very least, thinking through a scenario like this (replete with path-dependency and feedback effects) makes it difficult to simple say "Europe in crisis, Euro goes down" and use that as a guide to trading. Life is more complicated than that.

Month-End Recap, Nov 2010

The second installment of a new feature: a very quick summary of my investment positions, to be published monthly. This is not investment advice and should not be construed as such.

I am currently 90% invested, as follows:

57% Agricultural commodities
10% Other commodities
16% Emerging market equities
07% Miscellaneous equities
10% Cash

My largest position continues to be in soybeans, followed by sugar.

A rather boring month for my portfolio, to be honest. PL-wise I was down a very small amount, small enough to be considered mere noise in the context of my YTD returns. (Many a trader has said these words and lived to regret them, ha ha).

I usually try to be between 85% and 105% invested, so I am below my average exposure here. Indeed, as planned and previously advertised, I reduced my net exposure in November, from 93% last month to 90% today, by selling some commodities and some Indian stocks. It's not that I'm particularly bearish or anything; it's just that I have no strong convictions at the moment and so would like to wait and see what develops while keeping some powder dry.

Paragraphs Worth Reading

Why write long blog posts explicating your point of view, when others have done your work for you (and much more eloquently I might add)?

Here's the always-excellent Interfluidity on "hangover theory":

Proponents do claim that poverty in the sense of diminished consumption, painful financial losses, and “creative destruction” of cherished institutions usually attend the adjustment process, and they recognize all this is usually associated with unemployment. But hangover theorists argue that adjustment is worth doing despite the cost in employment, consumption, and disruption, not because those costs are good things. When they do argue that “pain is good”, it is along very conventional lines of moral hazard. It is not that the macroeconomy “deserves” to suffer, but that foolish lenders and borrowers, specific misallocators of capital and overconsumers, ought to suffer disproportionately pour encourager les autres. Hangover theorists, like smart Keynesians, promote policies intended to shorten depressions when they occur. Austrians ask that bad claims quickly be recognized and devalued, so that economic activity can go forward without a debt overhang. Keynesians urge government action that conjures financial income from thin air, risking devaluation of old claims by inflation. There are different tradeoffs between moral hazard, sharp incentives, and political feasibility among the two approaches, but both seek to repair balance sheets and create a clean slate going forward.

And here's commenter sardonic_sob on the same topic:

I understand completely, and furthermore agree completely, with the idea that if we wiped out all the bad debt etc tomorrow but everybody just got up and went to work and nobody panicked we would have no problem making enough food and housing and cars and big-screen TV’s and so forth for everybody. The problem is that we will not DO that. We will continue to issue massive amounts of real or implied debt to try to keep anybody from losing and the net result is that the malinvestments will not be purged until they grow so large that they just can’t keep the plates spinning anymore. Then everybody WILL panic and nobody will get up and go to work because that’s just how human beings are.

And lurking ahead is the spectre of Peak Commodities, which nobody is worried about because we can just tweak our economy like a big machine, and if prices get too high we can just pull on the pullem and push on the pushem and fix it, right? However, our system requires massive amounts of low-cost energy and materials to fuel growth. (Without growth debt service becomes impossible and see prior paragraph.) You can’t print oil, coal, rare earths, or potassium. Don’t get me wrong: while I find the Olduvai Theory eerily compelling I firmly believe that we have the technical capability to get ourselves out of this mess. But we aren’t using it because we are devoting so much energy to keeping everything the way it is. This will work until it doesn’t, and we don’t have a Plan B. (That last sentence is pretty much my entire objection to economic manipulation in a nutshell.)

Both posts are well worth reading in entirety.

Take Me Down to the Paradox City

Assume, for a minute, that Paul Krugman is 100% correct in his analysis of the economy: assume that we are indeed in a liquidity trap, and the only way to escape the trap is through higher inflation. What's the best way to create this higher inflation? Why, through inflation expectations, of course. And what's the best way to foster inflation expectations? Well, here are some ideas:

- complain endlessly about government deficits;
- claim that QE2 will debase the dollar;
- whine about higher food and gas prices;
- tout gold as the ultimate investment.

Conversely, what's the absolute worst way to create an inflationary mindset in the populace? Hmm, I don't know, but writing a New York Times column that constantly warns of the dangers of deflation while pooh-poohing claims of inflation current or future, real or imagined -- that's gotta be pretty high on the list.

So within the framework of Prof. Krugman's own model, it's the right-wing fringe that is doing what's best for America, and Prof. Krugman who's doing what's worst.

But let's not steal (credit) from Paul only to pay (credit to) Peter. The situation is in fact almost perfectly symmetric. Consider Peter, Peter Schiff that is. He is a well-known inflationista and, by his own admission, owns lots of gold and other commodities ("real assets") on behalf of his clients. Yet he's constantly berating the Fed for its easy dollar policy, and calling for tighter monetary and fiscal conditions. Again, it would seem that Schiff's antagonists are doing what's best for his portfolio, while he himself is doing what's worst.

What a wonderfully paradoxical world we live in!

Positive Feedback, for a change

Nattering nabobs of negativity? Nyet! Instead of finding further fault with economists who I disagree with, let me share some interesting articles from economists who I agree with.

First, Jim Hamilton reports on a beautifully simple test for inflation: the rolling correlations between various commodity prices. It turns out that these correlations have increased quite significantly in recent months and years. This is strong suggestive evidence that there is a common factor driving all prices higher. What could that factor be? Hmm, I wonder.

Second, Steve Waldman has a great post on the role of morality in economics. Is there such a role? He says yes: “The thing is, human affairs are a morality play, and economics, if it is to be useful at all, must be an account of human affairs”. I couldn’t agree more. There’s a follow-up post here.

Third, Raghu Rajan has two policy suggestions that are exactly the same as my own: “The US should dial back its aggressive monetary policy, focusing on repairing its own economy’s structural problems, while emerging markets should respond by allowing their exchange rates to appreciate steadily, thereby facilitating the growth of domestic demand.”

Contra Krugman, Continued

A few follow-ups to my previous post.

First, of course, the obvious question: why does any of this matter? So what if Government Gus has to pay a slightly higher interest rate on his debts? Won’t the benefits of his spending (higher employment, income and consumption, which combine to help the private sector clean up its balance sheet) outweigh the costs?

I don’t think they will. And the reason, as usual, is positive feedback. If the tipping point is reached, Gus won’t have to pay a ‘slightly higher’ rate on his debts; he will have to pay a rate that is significantly higher. High enough to burst the bond bubble and send foreign investors running for cover; high enough to send the dollar plummeting; high enough to put into serious doubt the government’s ability to roll over its debt. The US could end up in a situation like Greece. Worse, in fact, given the size and importance of the US economy, the US bond market and the US dollar.

The bursting of a bond bubble is far more dangerous than the bursting of an equity bubble or a real estate bubble. Immediate consequences include massive benefit cuts (social security and medicare), large tax increases and high inflation. Delayed consequences include steep declines in the standard of living, social unrest, and possibly war. Any policy that increases, however minutely, the likelihood of such outcomes should be considered very very carefully: is it really worth it? And in the case of QE2, I don’t think it is.

Second, I have just read through several hundred NYT blog posts by Prof. Krugman, and I notice that he has (explicitly or implicitly) addressed several of the arguments I made in my previous post. I would like to counter his points, one by one.

But before I do so, I want to make it clear that there is no personal or political animus behind my current stance. For what it’s worth, I was and am a great admirer of Prof. Krugman, as an economist and as a communicator. And I suspect that my policy baseline is very similar to his (pro free markets but with a strong appreciation of their limitations). In many cases and on many topics I agree with everything he writes.

Having said all that, I think he is dead wrong when it comes to the bond market and how it interacts with optimal government policy. And since that is a subject on which I consider myself an expert, I feel duty-bound to comment, at length. Hence my current series of blog posts.

On to Prof. Krugman’s points, in italics below.

“I base my argument on fundamentals, not market signals”

A bit of background: some critics (not me) have pointed to the fact that Prof. Krugman did not believe in the accuracy of market prices in 2006 (at the peak of the housing bubble), but seems to believe in their validity today (when it comes to interest rates). Prof. Krugman’s response to this criticism is that in all cases he is building from fundamentals, and not relying on market signals.

Fair enough, is what I say. There’s no rule that states you have to agree with the market all the time, or for that matter disagree with the market all the time. Sometimes you may think prices are justified, at other times you may think they’re incorrect. That’s fine.

What’s not fine, however, is to then use market prices as ‘additional support’ for your fundamental thesis. If you’re building from fundamentals, then fundamentals should be all you talk about. It’s not fair to constantly cite (as Prof. Krugman does) the low level of interest rates as support for your position that the market is unconcerned about deficit spending. Especially if at other times you are willing to discount market prices since they don’t conform to your position. This I think is hypocritical.

“QE2 does not materially affect the path of future deficits”

I agree that QE2 as currently envisaged won’t really affect deficits; it’s too small (or, equivalently, the current level of deficits is too big!). For the same reason, I think QE2 will be largely ineffective when it comes to its primary purpose, which is boosting spending¹.

But that’s irrelevant. The relevant mechanism here is positive feedback operating on traders with short horizons, who know that they’re in a Keynesian beauty contest. The actual level of deficits matters less than the psychological perception thereof.

This of course leads neatly into Prof. Krugman’s next point:

“Explanations that invoke market psychology are worthless”

With all due respect to Prof. Krugman as a brilliant academic economist, I think I’m much better qualified to judge the value of psychology in markets than he is. And speaking with the experience of over a decade as a (fairly successful) hedge fund trader, I have to say that Prof. Krugman is simply wrong. Psychology, herding, momentum, feedback, call it what you will: it matters, it really does.

Again, note that by invoking ‘psychology’ I am not invoking ‘irrationality’. It is perfectly rational for traders in a Keynesian beauty contest to care about other people’s (no doubt subjective) perceptions of value; indeed, that’s the whole point of Keynes’ argument.

“Critics have their own personal or political agenda”

I addressed this in my preamble; let me add here, for the record, that I am not a US citizen, do not live in the USA, and do not pay US taxes. My personal stake in US fiscal / monetary policy is minimal. However, I do believe that a strong and healthy US economy is in the best interests of the world at large, and I would like to see such an outcome eventuate. Political economy need not be a zero-sum game.

“Critics were wrong about the dotcom bubble and the housing bubble; why should we listen to them now?”

There is a whiff of ad hominem in this point, nonetheless I think it’s justified; after all economics is an inexact science with no impartial arbiters, and there are lots of hacks out there who are either incompetent or malicious or both. I think it’s fair to ask ones’ critics what their credentials are, and if they have a track record of being consistently and risibly wrong, then it’s fair to ignore them.

For what it’s worth, my first ever professional trade, shorting USD swap spreads in 2000, was based on the macroeconomic conviction that the dot-com bubble would burst, pushing tax receipts lower and necessitating increased Treasury issuance. In 2001 I predicted (not online, unfortunately) that low interest rates would lead to a housing boom and potentially a housing bubble. In 2004 I set my first small shorts in homebuilder stocks. I added to these over the next few years; by 2007-08 I was short Toll Brothers, Fannie Mae, Freddie Mac, Citibank and Goldman Sachs. Every one of these trades made money. I have made many mistakes in my time as a trader, but failing to recognize the dot-com and housing bubbles was not one of them.

Of course, I could still be wrong about what happens next; I could be imagining a bond bubble where none exists. Past performance is no guarantee of future returns. But at any rate I think I deserve to be taken seriously, as a credible analyst of markets.

“Inflation is not a worry; core CPI is at just 0.8% yoy”

This point is usually bracketed with some snide remarks about inflationistas always being wrong; this time, I will ignore the ad hominem, and confine myself to four points in reply:

First, this is a statement about the past and the present, not about the future, and thus has limited predictive power, especially with respect to a measure as driven by expectations as is inflation. It’s equally relevant (or irrelevant) to point out that just 2 years ago, all-items CPI was running at 5% yoy.

Second, core CPI (that is, CPI excluding food and energy) is a terribly flawed measure. Food and energy prices may be volatile, and demand for them may be price-inelastic, but if they show a decade-long secular uptrend, then they should be included in any accurate inflation index.

Third, even non-core CPI is suspect, because of all the hedonic and other adjustments that have been made over the years. Almost every adjustment seems to have biased CPI downwards. Is it mere coincidence that the entities that publish these numbers have an incentive to keep them low? I think not.

Fourth and most important, I believe the macro dynamics at play make CPI (whether core or all-items, whether hedonically adjusted or not) an irrelevance. The danger is not CPI inflation, it is asset price inflation. As I wrote on this blog some time ago:

China has exported deflation, but this has been concentrated in very specific segments of the economy: in the prices of retail goods, and in worker salaries. It so happens that these segments are precisely the ones captured in standard measures of consumer inflation. Central bankers, lulled by this quiescence in measured inflation, have time and again erred on the side of loose monetary policy, leading directly to the asset price bubbles that have done so much harm in recent years.

Or to put it another way: China supplies certain items that are mostly included in CPI (labor and goods); China demands certain other items that are mostly excluded from CPI (food, energy, and assets – mainly bonds). Naturally, this distinction affects the quoted level of CPI. Ignoring this distinction means fundamentally misunderstanding the macro dynamics at work today.

“Critics have no coherent macro model of their own”

Actually, I do have a macro model of what’s going on, and I think it’s very similar to Prof. Krugman’s own. I am happy to concede that the US is in a liquidity trap similar to that of 1990s Japan, and I concur fully with the analysis in Prof. Krugman’s classic paper addressing the Japanese experience.

Where I differ from Prof. Krugman is in the policy implications of his analysis. Specifically, I disagree strongly with this paragraph, which many would call the key conclusion of that 1998 paper:

The way to make monetary policy effective [in a liquidity trap] is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.

I have no doubts that such a strategy would ‘work’. But the thing is, such promises have a way of getting out of hand. You can’t ask for ‘slightly higher’ inflation – say, from 1% to 4% – and expect matters to stop there. Inflation is all about expectations, and once expectations become unanchored, the sky’s the limit. Arthur Burns and William Miller (successive Fed chairmen in the 1970s) both tried to foster temporary ‘slightly higher’ inflation in order to boost employment. Both failed miserably: unemployment stayed stubbornly high while inflation skyrocketed. It took Paul Volcker and two deep recessions to bring it back under control.

I think this a clear case of the cure being worse than the disease. But then, what’s the alternative? This brings us to Prof. Krugman’s last and best point:

“Critics have no policy solution of their own”

Okay, so I don’t believe that the Fed should promise to irresponsibly deliver inflation. And I don’t believe that the Treasury should spend trillions of borrowed dollars to bail out the consumer. So what do I believe? How do I propose to get the economy out of its current recessionary mire?

Sadly, I don’t think there’s an easy answer. Economic policy is not a magic bullet; it cannot achieve the impossible. And to expect that 300 million Americans can be returned to the same patterns of income, employment and consumption that obtained before the crisis, with no adverse long-term consequences, is to expect the impossible.

Why so? Because those patterns were always unsustainable. For many years, the United States has been consuming more than it produces; importing more than it exports; spending vast sums on unnecessary wars; and spending not enough on education, infrastructure, research and technology. These deep structural imbalances were allowed to persist by a complex global financial web, which was in turn driven by the short-term incentives of participants around the world (from the Wall Street mortgage machine, to Bretton Woods II and the Asian accumulation of Treasury debt). But ‘if something cannot go on forever, it will not’. In 2008 we saw the first unravelings of that global financial web. The process picked up momentum (positive feedback as usual), and before we knew it we were in the Great Recession.

This unraveling is not something that can be easily reversed, or perhaps reversed at all. And perhaps it should not be. After all, we have been here before. When the dot-com bubble burst, the Greenspan Fed eased monetary policy to an unprecedented degree, in order to avoid short-term pain. The result was an even bigger bubble, in housing. And now that the housing bubble has burst, Prof. Krugman wants the Bernanke Fed / Geithner Treasury to break new frontiers in easy policy, again to avoid short-term pain. The result will be a still bigger bubble, in bonds. You can’t play this game forever; sooner or later the piper will have to be paid. And every new bubble inflicts more pain than the last, when it eventually bursts (see the fourth paragraph of this very blog post).

So my policy solution, insofar as I have one, is to embrace the unraveling. The recession won’t last forever. Over time, I expect to see some combination of a lower dollar, higher inflation and lower real wages in the United States. These will lead to a lower standard of living and higher exports. And these two consequences are the key: it is these, and these alone, which can see the United States break out of its rut. A lower standard of living and higher exports are necessary to repair private sector balance sheets, bridge the gap between production and consumption, and plug various deficits. But it will take a long slow grind to get there; we could easily see a decade or two of secular stagnation, a la Japan.

It’s not what I would have wished for. But it’s the least bad option.

Footnote

# ¹In fact, you could make a strong argument that for QE to be effective at all, it has to materially affect deficits; this is akin to the idea of being ‘credibly irresponsible’ which I shall address below. (No, Virginia, Ricardian equivalence does not hold in the real world).

Liquidity, Solvency, Switching Equilibria -- and Paul Krugman

Paul Krugman believes that we are in a liquidity trap (interest rates can’t go any lower), and that the only way to break out of it is via increased government spending. Here’s a column expressing his views (apologies for the long excerpt but I want to make sure I don’t quote him out of context):

One of the common arguments against fiscal policy in the current situation – one that sounds sensible – is that debt is the problem, so how can debt be the solution? Households borrowed too much; now you want the government to borrow even more?

What’s wrong with that argument? It assumes, implicitly, that debt is debt – that it doesn’t matter who owes the money. Yet that can’t be right; if it were, we wouldn’t have a problem in the first place. After all ... one person’s liability is another person’s asset.

It follows that the level of debt matters only if the distribution of net worth matters, if highly indebted players face different constraints from players with low debt. And this means that all debt isn’t created equal – which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past.

To see my point, imagine first a world in which there are only two kinds of people: Spendthrift Sams and Judicious Janets ... In the past the Sams have borrowed from the Janets to pay for consumption. But now something has happened that has forced the Sams to stop borrowing, and indeed to pay down their debt. For the Sams to do this, of course, the Janets must be prepared to dissave, to run down their assets. What would give them an incentive to do this? The answer is a fall in interest rates. So the normal way the economy would cope with the balance sheet problems of the Sams is through a period of low rates.

But what if even a zero rate isn’t low enough; that is, low enough to induce enough dissaving on the part of the Janets to match the savings of the Sams? Then we have a problem.

What can be done? One answer is inflation ... But what if inflation can’t or won’t be delivered?

Well, suppose a third character can come in: Government Gus. Suppose that he can borrow for a while, using the borrowed money to buy useful things like rail tunnels under the Hudson. The true social cost of these things will be very low, because he’ll be putting resources that would otherwise be unemployed to work. And he’ll also make it easier for the Sams to pay down their debt; if he keeps it up long enough, he can bring them to the point where they’re no longer so severely balance-sheet constrained, and further deficit spending is no longer required to achieve full employment.

Yes, private debt will in part have been replaced by public debt – but the point is that debt will have been shifted away from severely balance-sheet-constrained players, so that the economy’s problems will have been reduced even if the overall level of debt hasn’t fallen.

Prof. Krugman is correct as far as he goes. Increased (deficit-financed) government spending can indeed boost incomes, employment and consumption, and thus help the private sector clean up its balance sheet. Then when the private sector has recovered, government can unwind its fiscal expansion and return to running a primary surplus, thus paying down the (temporary) debt it has accumulated.

So all is hunky-dory? Not quite. We have skipped over a very crucial assumption in Prof. Krugman’s argument: the assumption that Government Gus is a ‘player with low debt’, and can thus borrow money at low interest rates, both now and in the future, for as long as it takes until the private sector has recovered and primary surpluses can be reinstated.

Is this assumption valid? Well, it certainly appears valid at the moment. After all, 30-year bond yields (the rate at which the Treasury finances its debt) are close to multi-year lows. Surely if the market were truly concerned about the size of government debt it would charge a higher interest rate on government bonds?

Not quite. Appearances can be deceptive. In this particular case, there are two errors that contribute to the mistake: a confusion between liquidity and solvency, and a misunderstanding of how markets work. Let’s take a deeper look at both of these.

Consider, first, the aforementioned two measures of fiscal position: solvency and liquidity.

Solvency is a ‘stock’: if your total assets are larger than your total liabilities, then you’re solvent.

Liquidity is a ‘flow’: if your monthly income is greater than your monthly expenditure, then you’re liquid.

Put another way, solvency is the level of your “assets minus debts” while liquidity is the derivative (the rate of change) thereof.

Now, you might think that solvency is somehow more important than liquidity, when determining the future of an enterprise. But this is not necessarily the case. You can be insolvent but stay in business for a long time, as long as you have the cash with which to pay your monthly bills. Conversely, you can be perfectly solvent but go out of business, if you don’t have cash in hand when the bill-collector comes calling.

This is a key point. Bankruptcy is always and everywhere a liquidity event. Nobody ever goes bankrupt because their consolidated balance sheet shows greater liabilities than assets. No, they go bankrupt because they can’t make a payment in the here and now.

Does that mean solvency is unimportant? Again, not quite. Because solvency and liquidity are not independent; they feed into each other. Specifically, it’s usually the perception of solvency (or insolvency) that drives the availability (or absence) of liquidity.

If you appear long-term solvent, you can often borrow money to tide you over any short-term liquidity problems. What’s more, the interest you pay on the borrowed money will be low, reflecting your perceived status as a ‘safe’ borrower, and thus enhancing your solvency. High credit quality is thus a self-fulfilling prophecy. (Once again, it’s our old friend positive feedback!)

And the converse is also true. If you appear insolvent, it’s hard to borrow money except at punitive rates; the high cost of servicing your debt further degrades your solvency, and before you know it you are in a ‘liquidity death spiral’ and out of business.

How does this apply to Government Gus? Well, there’s no question that Gus has ready access to liquidity; that is the message of the capital markets (30-year bond yields at 4%). But Gus is most definitely insolvent:

The fiscal gap is the value today (the present value) of the difference between projected spending (including servicing official debt) and projected revenue in all future years ... Based on the Congressional Budget Office’s data, I calculate a fiscal gap of $202 trillion, which is more than 15 times the official debt. This gargantuan discrepancy between our “official” debt and our actual net indebtedness isn’t surprising. It reflects what economists call the labelling problem. Congress has been very careful over the years to label most of its liabilities “unofficial” to keep them off the books and far in the future.

(The quote is from BU’s Prof. Lawrence Kotlikoff, who specializes in inter-generational accounting.)

Prof. Krugman elides the distinction; he claims that because Gus is liquid right now, he will have no problem borrowing money for as long as it takes to help the economy recover; and long-term solvency simply does not matter.

But it does. And to understand why, you have to understand how markets work.

See, traders don’t really care about long-term solvency per se (or long-term anything, for that matter). Traders only care about short-term price action, because that’s what they get paid for. Annual bonuses depend on annual profits.

And short-term price action is a mess of positive and negative feedback, self-fulfilling prophecies, tipping points and overshooting.

Right now, 30-year bond yields are low because we’re in a feedback loop, wherein banks borrow money from the Fed at 0% and deposit it in Treasury bonds at 4%. The low level of interest rates convinces everyone that government insolvency and inflation are nothing to worry about. And that in turn justifies further buying of bonds.

Thus we are in what appears to be a stable equilibrium. But we could easily flip over into another less healthy equilibrium. If, for whatever reason, the market loses some of its confidence in the government’s ability to roll over its debt, then positive feedback will begin to operate in the opposite direction¹. Rates will go higher, debt service payments will go higher, and the liquidity/solvency situation will get worse, causing rates to go higher still. We saw an example of precisely this dynamic in Greece earlier this year.

Another way to look at it is this. There is no ‘right’ and ‘wrong’ when it comes to trading; no ‘fundamental value’ or ‘fair price’; there is only ‘profitable’ and ‘unprofitable’. And the sole determinant of whether a particular trade is profitable or not, is the behavior of other traders. (Keynes’ famous analogy of the beauty contest). If the market as a whole believes that Government Gus is liquid, then the optimal strategy for any given trader is to lend money to Gus and take home the carry; if the market as a whole believes that Government Gus is broke, then the optimal strategy is to squeeze him. And the belief system of the market as a whole can turn on a dime.

This is what Prof. Krugman does not seem to understand: the rapidity with which markets can go from one equilibrium to another, once a tipping point is reached, thanks to feedback effects. And the worse the initial solvency position of the government, the more likely it is that the tipping point will be reached. This is the link between solvency and liquidity; it has nothing to do with fundamentals, and everything to do with trader behaviour in a feedback market.

So we’re in a race against time. Will deficit spending resuscitate the private sector before the debt service tipping point is reached? That, indeed, is the question, and it is one that Prof. Krugman does not even ask, let alone answer.

(Personally I’m pessimistic on both fronts. I doubt that government spending will suffice to repair private sector balance sheets or confidence any time soon; Japan is Exhibit Number One for how an economy can remain in the doldrums for years despite massive government spending². And I think the tipping point may come sooner rather than later, simply because there seems to be an utter lack of political will to do anything at all about the deficit situation. I hope I am proven wrong.)

Footnotes

# ¹You don’t need a complete loss of confidence; all you need is a change on the margin, and positive feedback takes care of the rest.

# ²I believe Prof. Krugman’s response to the ‘Japan critique’ is to say that Japan’s own implementation of QE was not aggressive enough. There are two problems with this response. First, of course, it is a classic unfalsifiable argument. Second, and more important, I believe that one should defend or attack QE as it is, not QE as it ‘should be’. Perhaps in an ideal world we would get a sufficiently large QE to in fact solve the economy’s problems just like Prof. Krugman hopes. But in the real world the amount of QE that is politically tenable is likely to fall well short of this ideal amount. And there is no reason to expect that the effectiveness of QE scales monotonically with size; it is entirely possible that ‘no QE’ will be better for the economy than ‘half-hearted QE’, albeit worse than ‘ideal QE’.

Month-End Recap, Oct 2010

This is a new feature: a very quick summary of my investment positions, to be published monthly. This is not investment advice and should not be construed as such.

I am currently 93% invested, as follows:

59% Agricultural commodities
11% Other commodities
17% Emerging market equities
6% Miscellaneous equities

My largest position is in soybeans, followed by sugar.

I usually try to be between 85% and 105% invested, so I am a touch below my average exposure here. Indeed I plan to drop down to around 90% in the next few weeks or months, mainly through selling EM stocks especially India.

Inflation? What Inflation?

Buttonwood notes that commodities have been on a tear lately:

Higher wheat and metals price have been hitting the headlines, so it is no surprise that the all-items index is up 8.4% on the last month. It is more surprising that it has risen 28.1% over the last year. Furthermore, this is not a boom that is driven by oil. The crude price has only risen 10.2% over the last year.

Buttonwood then asks a question:

Ben Bernanke warned last week that the level of inflation was too low for comfort. Indeed, the core rate is just 0.8%. Why aren't higher commodity prices showing up in the CPI?

Buttonwood answers the question:

In part, this is down to lags; in part, it's down to the relatively small weight of commodities within the index. But it may be down to methodology. John Williams at Shadow Government Statistics runs an inflation measure that ignores all the methodological changes that have been made to the CPI since 1980; this has inflation running at 8.5%. A separate measure that ignores changes since 1990 has inflation running at 4.4%.

But then Buttonwood questions the answer:

My feeling is that, if inflation were as understated as the Shadow numbers suggest, it would have shown up somewhere else in the numbers (by analogy, if a company is fiddling its profits numbers, the evidence will probably show up in the cashflow figures). No-one is suggesting that the annual wage growth numbers are artificially low. So if prices have been rising much faster than wages, wouldn't that show up in declining consumer demand?

Buttonwood’s conclusion is that the understatement of CPI is not that big an issue.

I disagree, and here’s why. The period in question also happens to be a period of dramatic increase in the availability (and utilization) of consumer credit. Coincidence? I think not. Prices rose but wages did not; the only way to plug the gap was for the consumer to become ever more leveraged.

And then, the crash: after credit dried up in 2008, “declining consumer demand” is precisely what we have seen. It all fits.

Who's Pegged To Whom?

I find it revealing that when China hiked interest rates last week, the USD promptly rallied. Of course the rally was short-lived, but it confirms a suspicion I have long held: it's not the renminbi that is pegged to the dollar, it's the dollar that's pegged to the renminbi.

(Aside: treating the US and China as a single economic entity -- albeit one with large internal imbalances and frictions -- is a very useful construct when thinking about global trade flows. Maybe some day I will write a longer post about the implications of such a world-view).

(Another aside: quite a few macro traders believe in the DGDF (dollar goes down forever) hypothesis, for very good monetarist / inflationary reasons. But in my opinion the dollar won't really begin to decline until it is delinked from the world's fundamentally strongest currency.)

The Return of the Meta-Finance Blogger

Hello to all my faithful readers, and my apologies for the long hiatus. Apart from the usual excuses (being busy, being lazy, being otherwise inclined), the main reason I've written just 3 blog posts in all of 2010 is that quite frankly, global markets have been pretty boring, year-to-date. But that seems like it's changing; the last couple of months have seen some quite interesting dynamics take root. I plan to address a few of these in coming posts.

But with a difference: instead of my old style of writing lengthy disquisitions on particular subjects, I am going to try shorter and snappier posts which will hopefully nonetheless be interesting and insightful. And I am going to write more explicitly about topical issues (aka "market commentary") rather than sticking solely to abstract generalizations. As always, reader feedback (positive or negative, ha ha) is very welcome. Happy reading!

Michael Lewis on Michael Burry

Michael Lewis, whose writing I generally enjoy, has a new book out. It’s not about the financial crisis per se, but about a handful of traders who made huge amounts of money from the crisis. There’s an excerpt available on the Vanity Fair website, in which Lewis talks fairly admiringly about one such trader, Michael Burry.

I haven’t read Lewis’ book beyond this extract, nor do I know Burry personally (though I do know the trade he executed – it was a simple yet powerful idea, and full credit to him for conceiving it). But I do want to emphasize a couple of points that the VF article glosses over:

First, any story of this sort suffers from a huge amount of survivorship bias. For every Michael Burry or John Paulson who foresaw the crash and made money off it, I can name ten – nay, a hundred! – hedge fund managers who knew full well that there was a bubble in the housing market but could not get their timing right, and hence went bust¹. (Either they bled to death on the negative carry, or their investors got impatient and pulled their money). Of course none of these other managers got their stories recounted in Vanity Fair, which is where the bias comes in. Lauding survivors for their investment acumen is meaningless without knowing the a priori probability of survival. Hindsight is always twenty-twenty.

And why are the odds of survival so very low? This brings me to my second point. The way the article describes it, Michael Burry was in the perfect position to do the subprime-CDS trade. Over previous years he had outperformed the S&P by huge margins, in good years as well as bad; by not looking to maximize his AUM he could pick and choose his investors; said investors loved him and hung on his every word; and his funds were structured with long lockup periods. If anyone had the wherewithal (deep pockets as well as credibility) to take a few quarters of losses while waiting for the big payout, it was Michael Burry.

But no. Quoting Lewis:

[Burry] assumed he’d earned the rope to hang himself. He assumed wrong ... He had told his investors that they might need to be patient ... They had not been patient ... Many of his investors mistrusted him, and he in turn felt betrayed by them ... To keep his bets against subprime-mortgage bonds, he’d been forced to fire half his small staff, and dump billions of dollars’ worth of bets...

If even a trader in Burry’s strong position was forced to the very brink by irrational investor behavior, what hope for lesser souls?

My point here is that traders do not operate in a vacuum. If your investors are myopic and greedy, that forces you to be myopic and greedy as well. If your colleagues are picking up nickels in front of a steamroller, then you have to go after those nickels as well. In Wall Street’s current “quarterly-earnings-are-everything” mindset, you simply cannot afford to sit back and be patient if you want to keep your job.

Of course the equilibrium is unhealthy: decisions that are rational at the micro level for individual traders, add up to an irrational macro market situation. In other words, a bubble. Quelle surprise!

Footnotes

# ¹Conversely, I know plenty of hedge fund managers who either did not recognize, or chose not to recognize the bubble. For the most part these folks banked big bonuses pre-crash, and they haven’t had to return the money post-crash. Does this make them any dumber than Burry or Paulson, or any worse traders?

Moral Hazard and Conventional Wisdom

Was moral hazard, in the form of expectations of a bailout, responsible for the reckless behavior that led to the banking crisis? James Surowiecki argues, quite convincingly I think, that the moral hazard argument is overrated:

In order to believe that the banks engaged in reckless behavior because they assumed that if they got into trouble, the government would bail them out, you have to believe not only that financial institutions thought it would be fine if their share prices were driven down to near-zero as long as they were rescued in the end. You also have to believe that the banks knew that what they were doing was reckless, and that there was a meaningful chance that it would wreck their companies, but decided that it was still worth doing because if everything went south, the government would step in. And that, even before Dimon’s comment yesterday, always seemed improbable, because all of the accounts of the banks’ behavior in the years leading up to the crisis suggest that most of them were swept up in housing-market hysteria like everyone else.

In a way, the moral-hazard argument ascribes far too much foresight, intelligence, and rationality to the banks. It assumes they were coldly calculating the chances and consequences of failure and forging ahead nonetheless, when the reality seems to be that for the most part they were blissfully ignorant and arrogant about the flaws in their lending and investment strategies.

I think Surowiecki is correct as far as he goes, but he doesn’t go far enough. To me the interesting question is, just why were bankers so ‘blissfully ignorant and arrogant’? The Epicurean Dealmaker provides an eloquent answer:

I also explained that the fast pace and high pressure of the business tend to attract individuals who do not attach great importance to deep, theoretical, or introspective thought. Rather, quickness of intellect, nice interpersonal judgment, and a certain calculating capacity akin to the ability of practiced chess players to think several moves ahead are the most valuable and prized attributes in my industry. What I did not explain was the natural corollary to these observations; namely, that due to their vocational preoccupations and intellectual predispositions, investment bankers tend to be extremely adept and quick at sussing out and acting on what is commonly known as the conventional wisdom.

This should not be surprising, either. After all, investment bankers spend all their waking hours figuring out and relaying to clients what "the market thinks" about deals, securities, and prices. Investment banks are gatekeepers to the markets, whether underwriting securities, trading financial instruments, or structuring and executing mergers and acquisitions. And what is the market itself but a gigantic, multi-tentacled, complexly interlinked engine for the real-time calculation of conventional wisdom? Figuring out, anticipating, and shaping conventional wisdom is what investment bankers do. It is the ocean in which we swim.

(More words of wisdom from TED can be found here).

The Regulator's Dilemma

If there’s one idea that has achieved consensus over the past few months, it is that regulators were asleep at the switch as the credit bubble inflated. A better regulatory system would have preempted the bubble, precluded the need for bank bailouts, and saved the world much misery.

If only it were that easy!

Imagine that you are the regulator in charge of the banking industry. What are your aims?

Well, on the one hand you want to prevent ‘unwarranted’ bank runs. An unwarranted bank run is one in which the bank did nothing wrong, and is actually well-capitalized, but due to ‘irrational’ investor panic faces a potentially life-threatening short-term funding gap. Preventing unwarranted bank runs is what lies behind well-known CB catchphrases such as “contagion”, “systemic risks”, “lender of last resort”, and “too big to fail”.

On the other hand, you as the regulator are (moderately) in favor of ‘warranted’ bank runs. If a bank does something stupid, it should pay. Depositors should withdraw their money from badly-run banks, and you don't want to stand in their way. You don't want to bail out the incompetent; that’s deeply unfair to the competent, and it messes up incentives all through the system. (To quote one famous investor, “Bailouts are bad morality as well as bad economics”).

Unfortunately, these two aims are fundamentally incompatible. Because smart bankers will simply pile into precisely those trades which pose systemic risks!

Why should a banker take the trouble to build a unique portfolio, thus exposing himself to all sorts of idiosyncratic risk factors? If these idiosyncratic factors go against him, he will appear (uniquely) stupid, and will probably not be bailed out. It’s much better for him to pile into the same trade as everyone else¹. Then if things go sour, it will be a systemic crisis and so everyone will be bailed out, including the banker in question.

(This insight is nothing new; it is merely the compensation dynamic for 1 trader on a desk of 10 traders, applied to 1 bank in an economy of 10 banks, with bailouts substituting for bonuses.)

In fact the situation is even more perverse than it appears. A standard measure of trade quality is the risk-reward ratio: the lower this ratio, the better the trade. But if systemic crises and consequently bailouts are in play, then the reasoning becomes inverted. Losses from low-risk trades are, by definition, small; hence low-risk traders are unlikely to be bailed out. Conversely, losses from high-risk trades are, by definition, large and potentially life-threatening; hence high-risk traders will often be backstopped by the government. This is moral hazard at its most pernicious.

It gets worse. The more enthusiastically people herd into one (systemically risky) trade, the higher the odds of a bailout; the higher the odds of a bailout for a particular trade, the more people will want to enter that trade. Yes, it’s our old friend, positive feedback!

So what’s a well-meaning regulator to do? There are only two coherent choices, really: put an end to bailouts, or put an end to bank proprietary trading.

Sadly, I don’t see either of these happening.

Footnotes

# ¹ Throughout this post I use ‘trades’ as a convenient short-hand for ‘institutional strategic decisions’.