29/05/2009: Asset bubbles, cavemen and central bankers

Imagine you are a happy Pleistocene, a caveman hunting where saber-toothed tigers roam. Suddenly there is a soft, rustling noise behind you. You have two options: either you run, assuming a tiger is near, or you dismiss the sound as meaningless and continue to hunt. You may have made the right choice or the wrong one. In fact, there are two wrong choices here. If you run and there is no tiger, you miss the hunt. On the other hand, stay and you might end up a saber-toothed snack.

Behavioralists call the first mistake, spotting a pattern where there is none, a Type 1 error, and the second, missing a pattern when it is there, a Type 2 error. Humans generally make far more Type 1 errors than Type 2s. We are specialists in finding meaning or causality where none exists, as documented in psychologist Bruce Hood’s recent book, “SuperSense.”

Obviously Type 1 errors bear costs. As investors, they make us susceptible to “narrative fallacy,” when we succumb to the charm of a story purporting to explain why a particular asset rallies even though it may be pure fantasy. Nassim Nicolas Taleb illustrates this impulse profoundly in his book, “The Black Swan.”

We seldom make Type 2 errors, though we may do so implicitly when we choose the wrong pattern or explanation in a Type 1 mistake. Type 2 errors are usually much costlier than Type 1s. For our caveman, missing the hunt is far less costly than being eaten by a saber-toothed tiger.

During the past fifteen years, Type 2 errors obscured two costly asset bubbles. Not only were individuals wrong, but so were large financial institutions and even central banks. As with our caveman, a Type 1 error—running from a nonexistent bubble—only costs a missed investment opportunity. The Type 2 error of failing to recognize an asset bubble as it swells and quivers and hisses behind you, we now know, can be far more costly.

Central bankers seem particularly Type 2-prone in the face of asset bubbles. Former Fed Chairman Alan Greenspan didn’t recognize the Tech bubble, bloated by its fantastical valuation metrics, because he liked the narrative of a new economy spurred by technology-driven productivity gains. Current Fed Chairman Ben Bernanke argued as late as 2005 that pumped-up US house prices “largely reflect strong economic fundamentals.” The few who rang the bubble alarm over house prices were dismissed as Type 1 phobics, though we now see it was their detractors who committed a massive Type 2 error. And once that bubble burst, almost everyone got very, very wet.

These two big asset bubbles should make the case for central banks acting early, at the mere hint of a bubble-in-the-making, since early intervention costs far less than a Type 2 meltdown. But I suspect this is not the path central banks will chose, even after the current crisis. At the end of the day, central banks cannot defy political will: if they remove the punchbowl from the party too early, they invite the public’s wrath. So, like an ignored saber-toothed tiger, bubbles will surely continue to catch their prey.

15/05/2009: Bubblegum in the hair: China’s dollar dilemma

For the past two decades, the US and China have mirrored each other in a dance of deficits and surpluses. The US grew a massive current account deficit while China’s current account swelled. Normally, such an imbalance should correct through exchange rates. The dollar should have fallen against the yuan, but the Chinese didn’t let this happen. Through currency market interventions and especially by buying US Treasury bonds, the yuan was effectively pegged to the dollar. The result: China holds a whopping two trillion US dollars in currency reserves.

With the onset of the financial crisis, this imbalance grows ever less sustainable. Squeezed by the crisis and the worst recession in sixty years, the US has no choice but to devaluate the dollar. And this threatens to erode the purchasing power of China’s dollar reserves. Thus, China is also caught in a vise. They are looking for remedies, but it’s far from easy to get out from under the dollar mountain, as we shall see.

In a profound, widely cited paper in March entitled “Reform the International Monetary System,” People’s Bank of China President Zhou Xiaochuan urged replacing the US dollar as the world’s reserve currency with a diversified basket of major currencies controlled by the International Monetary Fund. Zhou’s idea is provocative, well-reasoned and utterly improbable, since America is unlikely simply to retire dollar from its position of power.

Maybe, some suggest, China could circumvent the dollar by increasing its gold reserves. Gold bugs around the world are abuzz that China has being buying the precious metal in a big way lately. However, despite recently increasing its holdings by 454 tons, gold still represents less than 2% of China’s total reserves. Raising that share to 10% would require buying five to six thousand tons of gold, more than two years worth of global mining output. Obviously, such a buying spree would drive up the price of gold and that is the rub. Gold is priced in US dollars and a higher gold price simply cuts the purchasing power of China’s dollar reserves. And ultimately, with its 8000-ton gold reserves, the US would profit far more than China from such a strategy.

Alternatively, since the Fed stands ready to buy US government bonds, China could try to sell some. With this money, it could then buy bonds denominated in euro or other currencies, allowing the dollar and the pegged yuan to depreciate against selected currencies. That the Chinese so far have not done so is puzzling. Perhaps they still have more faith in the greenback than in any other currency. Or they may simply not want to lessen the goodwill their massive dollar holdings extract from the US.

In the end, China faces a difficult decision. It can allow its currency to float freely and wait for the imbalances to ebb naturally away. Or it can attempt to intervene, though we honestly don’t see how. One thing is clear: the longer it waits, the more costly it will be for China and the riskier it will be for the US dollar.

01/05/2009: Warning: Panda’s green shoots could be fattening

Every economic cycle expands our vocabulary. The 1990s were the years of “irrational exuberance,” ending in the 2000-01 downturn dubbed the “shallow recession.” The recovery spawned the term “decoupling.” Today, having “fallen off a cliff,” the US economy is currently in a “shambles,” according to Warren Buffett. But Fed Chairman Ben Bernanke now sees “green shoots” of recovery emerging.

We are not so sure. While the US economy may be shrinking more slowly than it did at the end of 2008, it is still shrinking. And we expect it to continue to contract for another couple of months, if not quarters. Rather, we think China can more fairly claim those “green shoots.” After slowing sharply late last year, growth has resumed at an even faster pace than many economists had expected. This is surely good news, but can China’s growth pull the world economy along with it? And could the Chinese consumer replace the stricken US consumer as an engine of demand?

Some simple calculations give us the answers: No and no. China is either the world’s second- or the third-largest economy, depending on the exchange rate used. At market exchange rates – taking yuan at face value, converted into US dollars – China’s economy is between a quarter and third the size of the US economy. In terms purchasing power parity – acknowledging that a yuan buys far more in China than it would in the US when converted into dollars – China’s economy is somewhere between a third and a half that of the US.

Assuming, optimistically, that the Chinese economy is half as big as America’s, then GDP growth of one percent in China should have an impact on the world economy comparable to half-a-percent growth in the US. However, looking at consumption, we need to consider its importance in the overall economy. In the US, consumption still makes up roughly 70% of GDP, one of the highest levels in the world; in China, consumption is only 35% of GDP, one of the world’s lowest. Therefore to compensate for 1% consumption growth in the US, Chinese consumption must grow by fully 4%!

But wait, there is even more, or actually less, to the comparison. The US has roughly 300 million inhabitants. At 1.2 billion, China’s population is four times that sum. Thus, in fact, the average Chinese consumes sixteen times less than the average American. Not to mention their very different consumption patterns in each country.

The average Chinese consumer today rather resembles his or her peer in Japan or Europe in the 1950s, when consumption really began increasing demand for commodities. Now, consider that the current rebound in China is fueled by massive fiscal stimulus aimed at infrastructure projects, which are also commodity-intensive. It’s safe to assume that a Chinese rebound, if sustained, will push commodity prices higher in the coming quarters, lifting inflation rates along with them.

So China’s green shoots may not significantly boost global growth, though they may well help the world economy avoid deflation. And, with their hunger for commodities, these shoots might even be the first flush of surging worldwide inflation yet to come.