With a week to go until New Year’s Eve, 2010 ends with many problems unsolved that will continue to affect the first part of 2011.
The most obvious is the European sovereign debt crisis, or, as we prefer to call it: the crisis of the euro. So far, European leaders have failed to address the underlying problem of the crisis: to really function as a currency area, the Eurozone simply needs much more economic, fiscal and social integration. Instead, they have focused on reshuffling and guaranteeing governments' debts with evermore complex schemes. Despite these band-aids, the debts refuse to disappear. Ireland’s sovereign debt rating just got downgraded again. Portugal and Spain appear next in line to tap into European rescue packages. Hence, we expect the crisis of the euro to continue making headlines in the first months of 2011.
But, momentarily obscured by the chaos in Europe, another, equally formidable monster lurks: US debt. The big difference between Europe and the US, in my view, lies in the fact that in the Europe at least acknowledges the problem and, imperfect though they may be, pursues solutions. The US, in contrast, seems oblivious to its dangerous situation. Instead of tackling its debt issue realistically, Democrats and Republicans in Congress produced a compromise that extends the Bush tax cut for another two years while introducing supplementary tax cuts and subsidies for the middle class. According to first estimates, this new stimulus package – for that is what it is – will increase the already towering US debt mountain by an additional USD 550bn. Meanwhile, Federal Reserve Chairman Ben Bernanke hinted there could be a further sequel to the quantitative easing program….
US debt problems are not confined to the federal government. In his latest report, my esteemed colleague Mike Ryan, Chief Investment Strategist and Head of Wealth Management Research Americas, notes among the things that may happen in 2011 is the default of a high-profile municipality. According to Mike: "Credit conditions within the (US) municipal market remain challenging as the consequences of the financial crisis and associated recession have continued to weigh on state and local finances. (…) Although the general obligation debt of states such as California and Illinois or cities such as New York and Chicago is secure, municipalities like Detroit and Harrisburg could be forced to defer payments on their general obligation bonds."
Finally, the latest inflation data from China, the main driver of the global economy these days, will continue to challenge authorities there. For China's policy makers, walking the tightrope between overheating and too much cooling down will be a daunting task next year.
This said, looking back on 2010, we need to acknowledge that, despite its formidable challenges, it has been a rather good year in terms of investments, especially for those who could navigate the many obstacles. Our guidance for 2010, “Stay agile and alert,” remains firmly in place.
Thursday, December 23, 2010
Thursday, December 16, 2010
16/12/2010: The twin crises of confidence
The debate over what comes next, inflation or deflation, has vexed economists for a couple of years now. Some see the promise of inflation in the vastly expanded money supply after the financial crisis. Others see deflation's shadow looming since that bulging money supply has failed to revive anemic spending levels. We say the outcome is all a matter of confidence, or its lack.
Monetary theory examines the fluid dynamics of money in an economy, analyzing its supply and demand and how it affects things like prices and employment. At a first glance, monetary theory is simple enough. It is basically explained by the following formula: over a given period of time, the value of all economic activity equals the value of the available money multiplied by the number of times that money changes hands.
So far, so good. But dig deeper and it soon becomes apparent that the individual elements of this formula – which defines the so-called quantitative theory of money – are a lot more complicated than they appear. Even the notion of money itself needs more clarity. But perhaps the most elusive concept in the formula relates to the number of times money changes hands over a given period of time. This is what economists call the "velocity of money."
The velocity of money can only be measured indirectly, deduced from the other elements of the formula. Moreover, the forces behind the velocity of money are various and often not well understood. For one thing, they generally belong to those "soft" but no less powerful factors of psychology and human behavior. This is rather frustrating since the velocity of money is an important cog in the mechanism that transforms newly created money into price inflation.
The vagaries surrounding the velocity of money are often simply ignored. The less troublesome approach, which assumes the velocity of money is constant, is usually taken. But the indirect evidence makes it clear that the velocity of money is indeed subject to long-term trends and large fluctuations. It does, in fact, change.
In the aftermath of the financial crisis, a massive drop in the velocity of money could be indirectly but palpably observed in the US and in Europe. This means that impact of the money created by the central banks to restart the various national economies somehow gradually faded. Thus, despite the printing presses running red-hot, there has been no massive upward pressure on prices, no surge in inflation despite the vastly increased money supply.
One explanation for the drop in the velocity of money is certainly the diminishing confidence people and businesses have in the economy. This leads to caution about spending, to hoarding cash instead of using it for private consumption or corporate investments. Obviously, greater confidence in the economy could reverse this economic entropy, which the slowing velocity of money reflects. In parallel, an improving economy would likely see upward price pressures starting to build. This is exactly the scenario the Federal Reserve would like to see unfold.
But confidence in the economy is not the only thing that drives this situation. The confidence people have in money itself, in its basic role as store of value, also influences the velocity of money. The less confident they are in the money they hold, the more quickly they will try to get rid of it. In a phase of hyperinflation, the velocity of money is extremely high since no one wants to hold cash – which loses its value by the hour. They prefer to exchange the cash against virtually anything.
So there is a dark side to an increase in the velocity of money that the Fed would so warmly welcome. If the cause is not renewed confidence in the economic prospects, but instead reflects a loss of confidence in money itself as store of value, we could return to a 1970s-style scenario with low growth, high unemployment and, despite these constraints, mounting price pressure.
Such a resolution would deliver a verdict – both Solomonic and Pyrrhic – on the debate between those who take the fading confidence in the economy as a sign of impending deflation and those who think the waning confidence in money as a store of value augurs that inflation is just around the corner. We are beginning to wonder whether both sides are right. Perhaps the debate's ultimate outcome will deserve that ugly description of a chronically sick economy: stagflation.
Monetary theory examines the fluid dynamics of money in an economy, analyzing its supply and demand and how it affects things like prices and employment. At a first glance, monetary theory is simple enough. It is basically explained by the following formula: over a given period of time, the value of all economic activity equals the value of the available money multiplied by the number of times that money changes hands.
So far, so good. But dig deeper and it soon becomes apparent that the individual elements of this formula – which defines the so-called quantitative theory of money – are a lot more complicated than they appear. Even the notion of money itself needs more clarity. But perhaps the most elusive concept in the formula relates to the number of times money changes hands over a given period of time. This is what economists call the "velocity of money."
The velocity of money can only be measured indirectly, deduced from the other elements of the formula. Moreover, the forces behind the velocity of money are various and often not well understood. For one thing, they generally belong to those "soft" but no less powerful factors of psychology and human behavior. This is rather frustrating since the velocity of money is an important cog in the mechanism that transforms newly created money into price inflation.
The vagaries surrounding the velocity of money are often simply ignored. The less troublesome approach, which assumes the velocity of money is constant, is usually taken. But the indirect evidence makes it clear that the velocity of money is indeed subject to long-term trends and large fluctuations. It does, in fact, change.
In the aftermath of the financial crisis, a massive drop in the velocity of money could be indirectly but palpably observed in the US and in Europe. This means that impact of the money created by the central banks to restart the various national economies somehow gradually faded. Thus, despite the printing presses running red-hot, there has been no massive upward pressure on prices, no surge in inflation despite the vastly increased money supply.
One explanation for the drop in the velocity of money is certainly the diminishing confidence people and businesses have in the economy. This leads to caution about spending, to hoarding cash instead of using it for private consumption or corporate investments. Obviously, greater confidence in the economy could reverse this economic entropy, which the slowing velocity of money reflects. In parallel, an improving economy would likely see upward price pressures starting to build. This is exactly the scenario the Federal Reserve would like to see unfold.
But confidence in the economy is not the only thing that drives this situation. The confidence people have in money itself, in its basic role as store of value, also influences the velocity of money. The less confident they are in the money they hold, the more quickly they will try to get rid of it. In a phase of hyperinflation, the velocity of money is extremely high since no one wants to hold cash – which loses its value by the hour. They prefer to exchange the cash against virtually anything.
So there is a dark side to an increase in the velocity of money that the Fed would so warmly welcome. If the cause is not renewed confidence in the economic prospects, but instead reflects a loss of confidence in money itself as store of value, we could return to a 1970s-style scenario with low growth, high unemployment and, despite these constraints, mounting price pressure.
Such a resolution would deliver a verdict – both Solomonic and Pyrrhic – on the debate between those who take the fading confidence in the economy as a sign of impending deflation and those who think the waning confidence in money as a store of value augurs that inflation is just around the corner. We are beginning to wonder whether both sides are right. Perhaps the debate's ultimate outcome will deserve that ugly description of a chronically sick economy: stagflation.
Thursday, December 2, 2010
02/12/2010: Beware of economic idols
Eamonn Fingleton's 1995 book Blindside never fails to remind me of that famous verse from the Book of Ecclesiastes: "Vanity of vanities, all is vanity." Published just one year after the release of Hollywood blockbuster Rising Sun, Blindside reflects the decade's conviction that Japan was on a one-way path to global economic domination. Its subtitle – “Why Japan is still on track to overtake the US by the year 2000” – says it all.
Back in the early 1990s the world looked to the Japanese economy as its ideal: from keiretsu, the uniquely Japanese structure of large conglomerates, to the volunteer problem-solving groups known as quality circles. And yet this valorization reached its peak just before Japan's stock and housing market bubbles burst and ushered in the country's lost decade(s). Today, no one views Japan as a role model for economic policy: In fact, it haunts the global economy as a cautionary tale of mismanagement.
A string of economic idols came and went throughout the 1990s: first Japan, then the US, and finally “new Europe” with its Spanish economic miracle and Celtic tiger. Labor flexibility and deregulated financial markets became the new paradigms as allegiance shifted toward service economies at the expense of economic models based on manufacturing and industry. Alan Greenspan and Lehman Brothers CEO Dick Fuld – who was winning management awards right up until Lehman's collapse – were lauded as heroes.
Now yet another crisis has left a cherished economic model in tatters, and the world already seems to be on the hunt for new economic idols. We currently have two prominent front runners: Germany and China. Germany's proponents claim that its strength comes from its solid industrial base: In contrast to the US, the UK and the European periphery, tangible goods give German exporters their competitive edge, not intangible services. This view has its roots in a quite traditional Marxist worldview where only "things" matter.
But this overlooks the tremendous sacrifices Germany has made over the last decade in order to conserve its industrial base in a globalized world. German workers, for example, have not gotten any serious wage increases since 2000. These low labor costs would keep Germany ultra-competitive in Europe even with a stronger euro, but we cannot ignore the extent to which Germany benefits from the currency's weakness. Add to this the current Eurozone interest rates, which are far too low for the booming German economy, and we begin to see the danger of new bubbles fueled by cheap credit.
China, the other new economic role model, occupies a similar situation in terms of monetary policy. Its peg to the US dollar means interest rates are too low, and the country is already experiencing inflation pressures and a few real estate bubbles. Furthermore, China's much-praised long-term planning – which is not subject to short-term considerations like elections or quarterly corporate results – could soon outlive its usefulness. Long-term planning may be appropriate for an emerging market, but for a developed economy it can lead to overinvestment in losing sectors or hamper technological progress by underemphasizing competition and creative destruction.
Economic idols rise and fall like any other fad, and investors show a marked tendency to burn what they have adored and adore what they have burned. Yet careful analysis shows that all economic models have certain weak points, and their benefits come at the cost of corresponding drawbacks. The more openly these problems are discussed, the more likely we are to find workable solutions. Ironically, it is often the willful ignorance of idolatry that takes ordinary challenges and turns them into fatal flaw.
Back in the early 1990s the world looked to the Japanese economy as its ideal: from keiretsu, the uniquely Japanese structure of large conglomerates, to the volunteer problem-solving groups known as quality circles. And yet this valorization reached its peak just before Japan's stock and housing market bubbles burst and ushered in the country's lost decade(s). Today, no one views Japan as a role model for economic policy: In fact, it haunts the global economy as a cautionary tale of mismanagement.
A string of economic idols came and went throughout the 1990s: first Japan, then the US, and finally “new Europe” with its Spanish economic miracle and Celtic tiger. Labor flexibility and deregulated financial markets became the new paradigms as allegiance shifted toward service economies at the expense of economic models based on manufacturing and industry. Alan Greenspan and Lehman Brothers CEO Dick Fuld – who was winning management awards right up until Lehman's collapse – were lauded as heroes.
Now yet another crisis has left a cherished economic model in tatters, and the world already seems to be on the hunt for new economic idols. We currently have two prominent front runners: Germany and China. Germany's proponents claim that its strength comes from its solid industrial base: In contrast to the US, the UK and the European periphery, tangible goods give German exporters their competitive edge, not intangible services. This view has its roots in a quite traditional Marxist worldview where only "things" matter.
But this overlooks the tremendous sacrifices Germany has made over the last decade in order to conserve its industrial base in a globalized world. German workers, for example, have not gotten any serious wage increases since 2000. These low labor costs would keep Germany ultra-competitive in Europe even with a stronger euro, but we cannot ignore the extent to which Germany benefits from the currency's weakness. Add to this the current Eurozone interest rates, which are far too low for the booming German economy, and we begin to see the danger of new bubbles fueled by cheap credit.
China, the other new economic role model, occupies a similar situation in terms of monetary policy. Its peg to the US dollar means interest rates are too low, and the country is already experiencing inflation pressures and a few real estate bubbles. Furthermore, China's much-praised long-term planning – which is not subject to short-term considerations like elections or quarterly corporate results – could soon outlive its usefulness. Long-term planning may be appropriate for an emerging market, but for a developed economy it can lead to overinvestment in losing sectors or hamper technological progress by underemphasizing competition and creative destruction.
Economic idols rise and fall like any other fad, and investors show a marked tendency to burn what they have adored and adore what they have burned. Yet careful analysis shows that all economic models have certain weak points, and their benefits come at the cost of corresponding drawbacks. The more openly these problems are discussed, the more likely we are to find workable solutions. Ironically, it is often the willful ignorance of idolatry that takes ordinary challenges and turns them into fatal flaw.
Friday, November 19, 2010
19/11/2010: The emperor's new coins
Amid all the outcries about quantitative easing in the US and the sovereign debt crisis in Europe, a small piece of news out of Germany almost went unnoticed. Let me correct that oversight, since it reinforces my view that we cannot trust governments when it comes to managing the printing presses for cash, or, in this particular case, the minting machines for coins.
Under the bureaucratic haze of a necessary "adaptation of technical parameters," Germany's Finance Ministry, which runs the country's mint, announced that it plans to massively reduce the silver content in its commemorative ten-euro coins. The last two commemorative German coins were minted earlier this year to mark 175 years of the German railway and the 2011 Downhill Ski World Cup. They weighed 18 grams and used an alloy of 92.5% silver and 7.5% copper. From next year on, new coins will consist of only 62.5% silver and 37.5% copper and they will weigh just 16 grams. Reducing the silver content of the alloy and the overall weight of the coins drops the total amount of silver per coin from 16.25 grams to 10 grams. That's nearly a 40% debasement in one go.
Since 16.25 grams of silver was worth 11.10 euros on 12 November, the German Finance Ministry was actually making a EUR 1.10 loss on the ten-euro coins. With the new coins, the Finance Ministry will garner a profit of EUR 3.20.
Debasing the silver value of its coins in this way, the German Finance Ministry is honoring an ancient tradition of minters, one that goes back to the dawn of cash money. The Roman denarius, a silver coin, was used as a means of exchange for over five hundred years. Originally, it constituted a day's wages for a soldier or a laborer but it too went on an extreme diet over the centuries. Its 4.5 grams of silver content in the third century BC, slipped to 3.8 grams under Emperor Augustus in 16 AD, 3.2 grams under Nero in 60 AD, 1.66 grams under Caracalla in 217 AD, and finally to 0.2 grams under Aurelian in 270 AD. From Augustus to Aurelian, the overall debasement of the denarius amounted to roughly 95%, corresponding to an average inflation rate over those 270 years of 1.1% per year.
However, inflation was rather volatile during this period, with periods of rapid debasement and even phases of re-basement, which would correspond to deflation in modern economics. The latter usually occurred when Rome enjoyed a rich conquest and could plunder the silver reserves of a vanquished foe. From 250-270 AD, debasement accelerated dramatically, leading to an equivalent average inflation rate of roughly 10% per year and launching some early attempts at an overall currency reform.
The French King Philip the Fair (1268-1314) was another legendary currency debaser ("fair" refers to his looks, not his business ethics). Always short of funds due to his numerous wars, he first expelled the Jews from France and then the Lombards, confiscating their assets; then he levied unprecedented and highly contentious taxes on the Catholic Church and finally he ravaged the Knights Templar monastic order, staging show trials and executing their leaders as heretics. In fact, he owed the Templars vast sums of money. Currency debasement was another tool he used to fund his government, with contemporary chroniclers suggesting that in some years half of the budget was financed through devaluing the currency. This led to violent social unrest and earned him another nickname for all eternity: the Philip the Forger.
Kings were well known for their debasement policies. Referring to Louis XIV of France, French Enlightenment philosopher Montesquieu wrote: “… the king is a great magician, for his dominion extends to the minds of his subjects; he makes them think what he wishes. If he has only a million crowns in his exchequer, and has need of two millions, he has only to persuade them that one crown is worth two, and they believe it. If he has a costly war on hand, and is short of money, he simply suggests to his subjects that a piece of paper is coin of the realm, and they are straightway convinced of it.”
Obviously, Germany's debasement of its silver commemorative coins is trivial compared with the giants of currency debasement throughout history. On the other hand, coinciding as it does with the US Federal Reserve's second round of quantitative easing, which creates another 600 billion US dollars out of thin air, it illustrates once again that one can never blindly trust a government to defend the value of its currency.
Under the bureaucratic haze of a necessary "adaptation of technical parameters," Germany's Finance Ministry, which runs the country's mint, announced that it plans to massively reduce the silver content in its commemorative ten-euro coins. The last two commemorative German coins were minted earlier this year to mark 175 years of the German railway and the 2011 Downhill Ski World Cup. They weighed 18 grams and used an alloy of 92.5% silver and 7.5% copper. From next year on, new coins will consist of only 62.5% silver and 37.5% copper and they will weigh just 16 grams. Reducing the silver content of the alloy and the overall weight of the coins drops the total amount of silver per coin from 16.25 grams to 10 grams. That's nearly a 40% debasement in one go.
Since 16.25 grams of silver was worth 11.10 euros on 12 November, the German Finance Ministry was actually making a EUR 1.10 loss on the ten-euro coins. With the new coins, the Finance Ministry will garner a profit of EUR 3.20.
Debasing the silver value of its coins in this way, the German Finance Ministry is honoring an ancient tradition of minters, one that goes back to the dawn of cash money. The Roman denarius, a silver coin, was used as a means of exchange for over five hundred years. Originally, it constituted a day's wages for a soldier or a laborer but it too went on an extreme diet over the centuries. Its 4.5 grams of silver content in the third century BC, slipped to 3.8 grams under Emperor Augustus in 16 AD, 3.2 grams under Nero in 60 AD, 1.66 grams under Caracalla in 217 AD, and finally to 0.2 grams under Aurelian in 270 AD. From Augustus to Aurelian, the overall debasement of the denarius amounted to roughly 95%, corresponding to an average inflation rate over those 270 years of 1.1% per year.
However, inflation was rather volatile during this period, with periods of rapid debasement and even phases of re-basement, which would correspond to deflation in modern economics. The latter usually occurred when Rome enjoyed a rich conquest and could plunder the silver reserves of a vanquished foe. From 250-270 AD, debasement accelerated dramatically, leading to an equivalent average inflation rate of roughly 10% per year and launching some early attempts at an overall currency reform.
The French King Philip the Fair (1268-1314) was another legendary currency debaser ("fair" refers to his looks, not his business ethics). Always short of funds due to his numerous wars, he first expelled the Jews from France and then the Lombards, confiscating their assets; then he levied unprecedented and highly contentious taxes on the Catholic Church and finally he ravaged the Knights Templar monastic order, staging show trials and executing their leaders as heretics. In fact, he owed the Templars vast sums of money. Currency debasement was another tool he used to fund his government, with contemporary chroniclers suggesting that in some years half of the budget was financed through devaluing the currency. This led to violent social unrest and earned him another nickname for all eternity: the Philip the Forger.
Kings were well known for their debasement policies. Referring to Louis XIV of France, French Enlightenment philosopher Montesquieu wrote: “… the king is a great magician, for his dominion extends to the minds of his subjects; he makes them think what he wishes. If he has only a million crowns in his exchequer, and has need of two millions, he has only to persuade them that one crown is worth two, and they believe it. If he has a costly war on hand, and is short of money, he simply suggests to his subjects that a piece of paper is coin of the realm, and they are straightway convinced of it.”
Obviously, Germany's debasement of its silver commemorative coins is trivial compared with the giants of currency debasement throughout history. On the other hand, coinciding as it does with the US Federal Reserve's second round of quantitative easing, which creates another 600 billion US dollars out of thin air, it illustrates once again that one can never blindly trust a government to defend the value of its currency.
Friday, November 5, 2010
05/11/2010: Who's in charge here?
Who is in charge of monetary policy? At a first glance this is a simple question with an obvious answer: the central bank. But managing market expectations now also belongs to the Fed’s brief and some key lines of authority have been blurred.
In many countries, the central bank enjoys full independence from the government. This has proven itself to be a wise arrangement, since it ensures that the power of the printing press – of money creation – is not abused for political purposes. History offers ample evidence that when this function is in the hands of a government, money will be over-supplied. And too much money inevitably sends inflation out of control. Given our world of fiat money – backed only the confidence we have in it – central bank independence is vital. Or so we have been led to believe.
In fairness, central bankers have one of the toughest jobs around. They often take decisions that would surely fail in a public referendum. And as the warrantor of monetary stability, a central bank is not only accountable today but will also be judged harshly by future generations.
While they serve, central bankers rarely if ever get recognition for their good deeds. Paul Volcker, the Fed’s chairman between 1979 and 1987, was vilified during his time in office, even blamed for the double-dip recession of the early 1980s. Today he is universally hailed for reversing the era’s high inflation. And Alan Greenspan’s once impeccable reputation has certainly been tarnished by the financial crisis that followed his unprecedented five terms as Fed chairman, in 2006.
As William McChesney Martin, Jr., a previous Fed chairman, observed that the job of a central bank is “to take away the punch bowl just as the party gets going.” Obviously, this is not a job for people with a strong need for approval.
Over the past thirty years or so, following the overthrow of Keynesian activism in the late 1970s, central banks and monetary policy have evolved to become instruments of economic policy. In the process, they have acquired some new tasks, including that of smoothing out the rough edges of the business cycle. And most recently they have been tasked with managing market expectations.
But market expectations turn out to be rather hard to manage. Ultimately, it can become a game of who is managing whom? Who wields the real, decisive influence?
This dynamic has come to characterize the Fed during the Greenspan and Bernanke eras. By flooding the economy with liquidity after the stock market crash of 1987, the former Fed chairman enshrined the “Greenspan Put,” where the government essentially props up sagging markets by lowering interest rates. This cure-all was prescribed in response to the first Gulf War, financial crises in Mexico and Asia, the LTCM debacle, the Y2K tempest in a teapot, the burst Tech Bubble, the 9/11 attacks and the second Gulf War.
It worked reliably; that is, until it stopped working. It finally came apart when the housing market bubble burst and the banking system went into cardiac arrest. We are still in intensive care from this medicine.
But our infatuation with quick fixes endures. The latest iteration of the Greenspan Put, in our view, is the second round of money creation by the Fed called quantitative easing (QE2). According to Bloomberg, two weeks before announcing the size of its interventions, the Fed surveyed investors and bond traders, asking them how big a package QE2 would (or should) be. This can be seen as a form of reverse engineering, managing market expectations by asking market participants what to do.
But whatever it is, such efforts call the independence of this particular central bank into question. Who is ultimately in charge of setting US monetary policy? One thing is clear: a central bank that is too predictable is a powerless central bank; and a powerless central bank is obviously not in charge.
In many countries, the central bank enjoys full independence from the government. This has proven itself to be a wise arrangement, since it ensures that the power of the printing press – of money creation – is not abused for political purposes. History offers ample evidence that when this function is in the hands of a government, money will be over-supplied. And too much money inevitably sends inflation out of control. Given our world of fiat money – backed only the confidence we have in it – central bank independence is vital. Or so we have been led to believe.
In fairness, central bankers have one of the toughest jobs around. They often take decisions that would surely fail in a public referendum. And as the warrantor of monetary stability, a central bank is not only accountable today but will also be judged harshly by future generations.
While they serve, central bankers rarely if ever get recognition for their good deeds. Paul Volcker, the Fed’s chairman between 1979 and 1987, was vilified during his time in office, even blamed for the double-dip recession of the early 1980s. Today he is universally hailed for reversing the era’s high inflation. And Alan Greenspan’s once impeccable reputation has certainly been tarnished by the financial crisis that followed his unprecedented five terms as Fed chairman, in 2006.
As William McChesney Martin, Jr., a previous Fed chairman, observed that the job of a central bank is “to take away the punch bowl just as the party gets going.” Obviously, this is not a job for people with a strong need for approval.
Over the past thirty years or so, following the overthrow of Keynesian activism in the late 1970s, central banks and monetary policy have evolved to become instruments of economic policy. In the process, they have acquired some new tasks, including that of smoothing out the rough edges of the business cycle. And most recently they have been tasked with managing market expectations.
But market expectations turn out to be rather hard to manage. Ultimately, it can become a game of who is managing whom? Who wields the real, decisive influence?
This dynamic has come to characterize the Fed during the Greenspan and Bernanke eras. By flooding the economy with liquidity after the stock market crash of 1987, the former Fed chairman enshrined the “Greenspan Put,” where the government essentially props up sagging markets by lowering interest rates. This cure-all was prescribed in response to the first Gulf War, financial crises in Mexico and Asia, the LTCM debacle, the Y2K tempest in a teapot, the burst Tech Bubble, the 9/11 attacks and the second Gulf War.
It worked reliably; that is, until it stopped working. It finally came apart when the housing market bubble burst and the banking system went into cardiac arrest. We are still in intensive care from this medicine.
But our infatuation with quick fixes endures. The latest iteration of the Greenspan Put, in our view, is the second round of money creation by the Fed called quantitative easing (QE2). According to Bloomberg, two weeks before announcing the size of its interventions, the Fed surveyed investors and bond traders, asking them how big a package QE2 would (or should) be. This can be seen as a form of reverse engineering, managing market expectations by asking market participants what to do.
But whatever it is, such efforts call the independence of this particular central bank into question. Who is ultimately in charge of setting US monetary policy? One thing is clear: a central bank that is too predictable is a powerless central bank; and a powerless central bank is obviously not in charge.
Friday, October 22, 2010
22/10/2010: Explaining Chintalia
Legend has it that, after tasting succulent noodles during his travels, one of the discoveries that Marco Polo brought back from China became Italian pasta. We think Italy can finally repay this long-overdue debt by exporting its postwar currency policy to China.
Like many emerging markets, China is engaged in a convergence process. Its GDP-per-capita is catching up with levels in developed economies. Given where it started and its vast population, this process will still take many years. But it seems that China, like South Korea, Singapore or Malaysia before it, is inexorably advancing on the convergence path.
When a country grows richer and slowly closes the wealth gap with more developed economies, there are several inevitable consequences. One is that the prices it asks for its exports increase over time. Or, in more technical language, its domestic currency appreciates in real terms.
Real exchange rates not only express the nominal exchange rate – that is, how many units of one currency you get for another. They also determine the relationship between domestic and foreign prices, for example, how many Chinese noodles you can buy in the US for the price of a kilo of noodles in China. As China converges towards the US, then a real appreciation of its currency would mean you get more noodles in the US for the price you pay in China. China would be catching up with the Americans and hence becoming relatively richer.
The convergence that we are seeing today in China and other emerging markets took place in Europe following World War II. Both Germany and Italy exited the war with very low GDP-per-capita levels relative to the US. As they developed in the decades following the war, they caught up with America and saw a real appreciation of their currencies. However, this real appreciation took two different forms.
Germany’s pre-war history gave it a severe case of inflation phobia. The real appreciation of the German mark occurred through nominal exchange rate appreciation, while Germany’s inflation was kept very low. If you get more dollars for one German mark, then you will get more German sausages in the US for the price of a kilo of sausages in Germany, even though the price in Germany remains constant.
In Italy, the real appreciation took another route. The nominal exchange rate was kept constant (the lira actually even depreciated against the US dollar), but Italy experienced a very high inflation rate. If the price of pasta increases in Italy (inflation), then you will obviously get more pasta in the US when you spend an amount equal to the price of a kilo pasta in Italy, even though the exchange rate between the US dollar and the Italian lira remains constant.
Confronted with the real appreciation of their currencies, today’s converging economies have a choice. To state the extremes, they can either let their currencies appreciate nominally and keep inflation low, the German way, or they can follow the Italian way and keep their exchange rates under control, with the risk of surging inflation. Economics is ultimately a science of choices and trade-offs.
Calling for the yuan to appreciate, the US wants China to pursue the German way. The Chinese disagree. They argue that an abrupt appreciation would harm their economy. Opting for the more subtle, Italian way – more inflation in exchange for a constant exchange rate – China thinks it can boost domestic demand with less disruption than the German route offers. And more domestic demand in China will also mean more exports to China, even for the US.
An ancient Chinese proverb states: “With time and patience, the mulberry leaf becomes satin.” With time and patience, the yuan’s real appreciation through inflation will benefit US exporters much more than a quick-fix nominal exchange rate surge.
Like many emerging markets, China is engaged in a convergence process. Its GDP-per-capita is catching up with levels in developed economies. Given where it started and its vast population, this process will still take many years. But it seems that China, like South Korea, Singapore or Malaysia before it, is inexorably advancing on the convergence path.
When a country grows richer and slowly closes the wealth gap with more developed economies, there are several inevitable consequences. One is that the prices it asks for its exports increase over time. Or, in more technical language, its domestic currency appreciates in real terms.
Real exchange rates not only express the nominal exchange rate – that is, how many units of one currency you get for another. They also determine the relationship between domestic and foreign prices, for example, how many Chinese noodles you can buy in the US for the price of a kilo of noodles in China. As China converges towards the US, then a real appreciation of its currency would mean you get more noodles in the US for the price you pay in China. China would be catching up with the Americans and hence becoming relatively richer.
The convergence that we are seeing today in China and other emerging markets took place in Europe following World War II. Both Germany and Italy exited the war with very low GDP-per-capita levels relative to the US. As they developed in the decades following the war, they caught up with America and saw a real appreciation of their currencies. However, this real appreciation took two different forms.
Germany’s pre-war history gave it a severe case of inflation phobia. The real appreciation of the German mark occurred through nominal exchange rate appreciation, while Germany’s inflation was kept very low. If you get more dollars for one German mark, then you will get more German sausages in the US for the price of a kilo of sausages in Germany, even though the price in Germany remains constant.
In Italy, the real appreciation took another route. The nominal exchange rate was kept constant (the lira actually even depreciated against the US dollar), but Italy experienced a very high inflation rate. If the price of pasta increases in Italy (inflation), then you will obviously get more pasta in the US when you spend an amount equal to the price of a kilo pasta in Italy, even though the exchange rate between the US dollar and the Italian lira remains constant.
Confronted with the real appreciation of their currencies, today’s converging economies have a choice. To state the extremes, they can either let their currencies appreciate nominally and keep inflation low, the German way, or they can follow the Italian way and keep their exchange rates under control, with the risk of surging inflation. Economics is ultimately a science of choices and trade-offs.
Calling for the yuan to appreciate, the US wants China to pursue the German way. The Chinese disagree. They argue that an abrupt appreciation would harm their economy. Opting for the more subtle, Italian way – more inflation in exchange for a constant exchange rate – China thinks it can boost domestic demand with less disruption than the German route offers. And more domestic demand in China will also mean more exports to China, even for the US.
An ancient Chinese proverb states: “With time and patience, the mulberry leaf becomes satin.” With time and patience, the yuan’s real appreciation through inflation will benefit US exporters much more than a quick-fix nominal exchange rate surge.
Saturday, October 16, 2010
16/10/2010: Will this QE2 really float?
No, we are not talking about a British cruise ship. Our QE2 stands for a second round of quantitative easing, which is when central banks buy up government-issued debt, injecting money into the system to revive a sagging economy. The US Federal Reserve is considering another such buying spree to battle persistent deflationary pressures.
Another way to view QE is to see it as creating inflation. The minutes of the latest Fed meeting were explicit: Instead of avoiding deflation, the Fed now aims at provoking a healthy, in its view, round of inflation. While at first glance this might seem a minor shift in focus, a mere nuance, in fact it reflects a major policy bias.
Depending on the source of the numbers, QE2 could expand central bank money in the US by as much as two trillion dollars. If completely implemented, it would swell the US monetary base – all the money in public circulation or in commercial bank deposits held by the Fed – to five times its 2008 size, from USD 800bn to over USD 4trn (as in trillion).
QE1, as we might call the first wave of US quantitative easing, totaled roughly USD 1.5trn. It was aimed at stabilizing the banking system, which it did by purchasing the toxic assets from the balance sheets of financial intermediaries. This fresh money remained largely with the financial intermediaries and did not circulate in the broader economy. While it successfully stopped the liquidity crisis in the banking sector after the Lehman Brothers collapse, it did not reflate the economy. Indeed, credit remains the missing link in the struggling US recovery. Banks are still reluctant to lend, and overly indebted private households are still reluctant to borrow.
QE2 is likely to be a different sort of beast. Instead of healing the hemorrhages of financial intermediaries, the money will flow directly into the economy via the purchase of US government debt. As I noted in a previous editorial, this is nothing other than a monetization of debt, and it could, in my view, lead to a massive increase of inflation down the line.
With QE2, the Fed aims to accomplish several things. First and foremost, it wants to keep interest rates low at the long end of the yield curve, at least as long as investors’ inflation expectations remain subdued. Those low interest rates should be an incentive for households to borrow again, kick-starting the sluggish credit market.
That is the plan on paper, but it could well backfire. One thing is fairly likely: by flattening the yield curve, the Fed will make the lives of financial intermediaries more difficult. These institutions usually profit from steep yield curves, borrowing at the short end and lending at the long end. A flatter yield curve will slow the ongoing balance sheet repairs of financial intermediaries, which could make them even more reluctant to lend.
Not only that. By fanning expectations that interest rates could go even lower than they already are, the Fed could actually induce a wave of interest rate deflation. By this, I mean that households could postpone their borrowing in anticipation of even lower interest rates in the future. This is akin to deflation’s nasty effect, when purchases are delayed with the expectation that prices will decline yet further.
Another channel through which QE2 is supposed to support the US economy is the exchange rate. By buying US government debt with freshly printed money, the Fed is increasing the amount of US dollars in circulation. Hence, the price of the US dollar expressed in a foreign currency should fall, making US exports more competitive on international markets.
Here, again, the dots do not necessarily connect. If the Fed wants to use the printing presses to weaken the dollar, it needs to run them faster than the printing presses of all the other countries who are also trying to weaken their currencies (see: Japan, China or the UK). And should there be another euro crisis – which in my view is not unthinkable given the two-tiered recovery in Europe – the US dollar could strengthen again anyway.
Moreover, it is not certain that US exporters will really benefit even if the US dollar weakens. US growth has not been export-led for half a century. The notion that a weaker dollar would unleash a flood of US exports to China presumes that the US makes things that China actually wants to buy. We are not so sure.
In sum, QE2 offers a rather shaky prospect of a payoff for the real economy and an increased risk that inflation could dramatically surge. Defending quantitative easing, Fed Chairman Ben Bernanke recently said, “I do think that the additional purchases [of government bonds], although we don’t have precise numbers for how big the effects are … I do think they have the ability to ease financial conditions.” In my view, coming from the captain of this exercise, the person who should signal that he has everything under control, this hedged and foggy argument hardly inspires confidence.
Given the powerful tides and unpredictable currents it faces, this QE2 does not look very seaworthy at this point. Lifeboats, anyone?
Another way to view QE is to see it as creating inflation. The minutes of the latest Fed meeting were explicit: Instead of avoiding deflation, the Fed now aims at provoking a healthy, in its view, round of inflation. While at first glance this might seem a minor shift in focus, a mere nuance, in fact it reflects a major policy bias.
Depending on the source of the numbers, QE2 could expand central bank money in the US by as much as two trillion dollars. If completely implemented, it would swell the US monetary base – all the money in public circulation or in commercial bank deposits held by the Fed – to five times its 2008 size, from USD 800bn to over USD 4trn (as in trillion).
QE1, as we might call the first wave of US quantitative easing, totaled roughly USD 1.5trn. It was aimed at stabilizing the banking system, which it did by purchasing the toxic assets from the balance sheets of financial intermediaries. This fresh money remained largely with the financial intermediaries and did not circulate in the broader economy. While it successfully stopped the liquidity crisis in the banking sector after the Lehman Brothers collapse, it did not reflate the economy. Indeed, credit remains the missing link in the struggling US recovery. Banks are still reluctant to lend, and overly indebted private households are still reluctant to borrow.
QE2 is likely to be a different sort of beast. Instead of healing the hemorrhages of financial intermediaries, the money will flow directly into the economy via the purchase of US government debt. As I noted in a previous editorial, this is nothing other than a monetization of debt, and it could, in my view, lead to a massive increase of inflation down the line.
With QE2, the Fed aims to accomplish several things. First and foremost, it wants to keep interest rates low at the long end of the yield curve, at least as long as investors’ inflation expectations remain subdued. Those low interest rates should be an incentive for households to borrow again, kick-starting the sluggish credit market.
That is the plan on paper, but it could well backfire. One thing is fairly likely: by flattening the yield curve, the Fed will make the lives of financial intermediaries more difficult. These institutions usually profit from steep yield curves, borrowing at the short end and lending at the long end. A flatter yield curve will slow the ongoing balance sheet repairs of financial intermediaries, which could make them even more reluctant to lend.
Not only that. By fanning expectations that interest rates could go even lower than they already are, the Fed could actually induce a wave of interest rate deflation. By this, I mean that households could postpone their borrowing in anticipation of even lower interest rates in the future. This is akin to deflation’s nasty effect, when purchases are delayed with the expectation that prices will decline yet further.
Another channel through which QE2 is supposed to support the US economy is the exchange rate. By buying US government debt with freshly printed money, the Fed is increasing the amount of US dollars in circulation. Hence, the price of the US dollar expressed in a foreign currency should fall, making US exports more competitive on international markets.
Here, again, the dots do not necessarily connect. If the Fed wants to use the printing presses to weaken the dollar, it needs to run them faster than the printing presses of all the other countries who are also trying to weaken their currencies (see: Japan, China or the UK). And should there be another euro crisis – which in my view is not unthinkable given the two-tiered recovery in Europe – the US dollar could strengthen again anyway.
Moreover, it is not certain that US exporters will really benefit even if the US dollar weakens. US growth has not been export-led for half a century. The notion that a weaker dollar would unleash a flood of US exports to China presumes that the US makes things that China actually wants to buy. We are not so sure.
In sum, QE2 offers a rather shaky prospect of a payoff for the real economy and an increased risk that inflation could dramatically surge. Defending quantitative easing, Fed Chairman Ben Bernanke recently said, “I do think that the additional purchases [of government bonds], although we don’t have precise numbers for how big the effects are … I do think they have the ability to ease financial conditions.” In my view, coming from the captain of this exercise, the person who should signal that he has everything under control, this hedged and foggy argument hardly inspires confidence.
Given the powerful tides and unpredictable currents it faces, this QE2 does not look very seaworthy at this point. Lifeboats, anyone?
Sunday, October 10, 2010
10/10/2010: The perils of normality
Shattered nerves. Jumpy markets. The long hangover from the financial crisis is making everyone nostalgic for the bygone days of financial market stability.
The plague of uncertainty stalking the market today has been spawned by two violently opposed economic forces. On the one hand, we have the deflationary pandemic of deleveraging and debt reduction that followed the burst credit bubble. On the other, we have monetary and fiscal resuscitation measures of such astronomical dimensions that, without the context of a financial crisis, a tsunami of inflation would be a certainty.
One victim of these unprecedented circumstances is economic analysis itself. Forecasts and outlooks are, frankly, all over the place, which makes them even less useful than usual. The more extreme the scenario, it seems, the more space it wins in the media and the blogosphere.
Apocalyptic economic prophets are prospering in these untethered times. About the only point economists can agree on is that a return to “normality” is unlikely. What do we mean by normality? For the US it would be growth slightly above 3% and for Europe closer to 2%, with inflation for both regions at between 2 and 3%. Paradoxically, such an improbably rosy scenario – one that most people would welcome – could prove disastrous for many assets that have lately been appreciating. Why?
We often hear that investors are driven by one of two emotions – fear or greed. Today, those who are fearful focus on preserving their wealth by investing in what have traditionally been the safest of assets: gold, the Swiss franc and US Treasuries. Each of these assets has surged this year, making some pundits worry that they could be forming bubbles.
The greedy investors take another route. They pursue yield anywhere they can find it in today’s low-interest-rate environment. And lately they have extended their activities far beyond their normal boundaries, moving briskly into emerging markets and even into “frontier” markets.
This leads to some interesting paradoxes. For example, despite ever-bigger current account deficits, Turkey and Brazil are seeing foreign exchange reserves at their central banks soar, lifting their currencies to new highs against the US dollar and the euro. This phenomenon can be explained by one common factor: the massive inflows of foreign capital into these emerging markets.
We want to make a small observation here: The return to a “normal” macroeconomic environment would weaken the assets of both the wealth-preservers and the yield-seekers. With normalization, investors would return to more traditional assets and the funds now flowing into the crisis-driven investments would dry up.
Investors who do not fully embrace the pessimism currently espoused by many economists should be even more cautious than the fearful investors. We think they should diversify wisely now, to ready themselves for the perils of normality’s possible return.
The plague of uncertainty stalking the market today has been spawned by two violently opposed economic forces. On the one hand, we have the deflationary pandemic of deleveraging and debt reduction that followed the burst credit bubble. On the other, we have monetary and fiscal resuscitation measures of such astronomical dimensions that, without the context of a financial crisis, a tsunami of inflation would be a certainty.
One victim of these unprecedented circumstances is economic analysis itself. Forecasts and outlooks are, frankly, all over the place, which makes them even less useful than usual. The more extreme the scenario, it seems, the more space it wins in the media and the blogosphere.
Apocalyptic economic prophets are prospering in these untethered times. About the only point economists can agree on is that a return to “normality” is unlikely. What do we mean by normality? For the US it would be growth slightly above 3% and for Europe closer to 2%, with inflation for both regions at between 2 and 3%. Paradoxically, such an improbably rosy scenario – one that most people would welcome – could prove disastrous for many assets that have lately been appreciating. Why?
We often hear that investors are driven by one of two emotions – fear or greed. Today, those who are fearful focus on preserving their wealth by investing in what have traditionally been the safest of assets: gold, the Swiss franc and US Treasuries. Each of these assets has surged this year, making some pundits worry that they could be forming bubbles.
The greedy investors take another route. They pursue yield anywhere they can find it in today’s low-interest-rate environment. And lately they have extended their activities far beyond their normal boundaries, moving briskly into emerging markets and even into “frontier” markets.
This leads to some interesting paradoxes. For example, despite ever-bigger current account deficits, Turkey and Brazil are seeing foreign exchange reserves at their central banks soar, lifting their currencies to new highs against the US dollar and the euro. This phenomenon can be explained by one common factor: the massive inflows of foreign capital into these emerging markets.
We want to make a small observation here: The return to a “normal” macroeconomic environment would weaken the assets of both the wealth-preservers and the yield-seekers. With normalization, investors would return to more traditional assets and the funds now flowing into the crisis-driven investments would dry up.
Investors who do not fully embrace the pessimism currently espoused by many economists should be even more cautious than the fearful investors. We think they should diversify wisely now, to ready themselves for the perils of normality’s possible return.
Friday, October 8, 2010
08/10/2010: No plan B for the A-team
If you don’t feel inspired to draft an economic treatise, you’ve finished the newest Swedish crime novel, and sleep still eludes you on an intercontinental flight, you can always catch up on the latest Hollywood blockbusters. You might not bother to see them in a theater, but it’s a long flight.
A couple of days ago, trapped in such a state of mind and body, I watched “The A-Team” on the in-flight entertainment panel. Thinly based on the formulaic hit TV series of the 1980s, there was plenty of good-guys-versus-bad-guys action and lots of pyrotechnical chase scenes. In the end, rest assured, the good guys win, and one of them even gets the girl. But what tickled my economist’s antennae was the storyline: The A-Team’s mission was to recover stolen plates used for printing US hundred-dollar bills. As their CIA handler put it, they had to get those plates back before some rogue element uses them to print “unbacked currency.” Sounds grave, doesn’t it?
Indeed, my reaction was, “So what?” Currency hasn’t been backed since the collapse of the Bretton Woods system in 1973. Until then, you could get a dollar’s worth of gold from the Federal Reserve for each dollar bill you turned in. Now, all you’re likely to get in exchange from the Fed is another dollar bill (and a puzzled look from the person behind the counter).
What actually supports a paper currency’s value? Nothing, it turns out, other than our steadfast belief that it is “worth” something. The entire, vast international monetary system is built upon this self-fulfilling confidence. Inflation – when a currency is losing its value – reflects waning confidence in that currency. This would logically mean that deflation’s lower prices indicate a currency has risen in value. In other words, our confidence in it as a store of value has increased.
But this is one of those times when logic and reality remain far apart. Economists have a useful term for describing how much money flows through an economy. They call it the monetary base. This refers to money in public circulation or in commercial bank deposits held at the central bank. Does the tidal wave of unbacked US dollars now flooding the monetary base of the US really reflect greater confidence in the dollar’s value? This amount has soared from 800 billion to a dizzying 2 trillion dollars since 2008.
Has the financial crisis really made us more confident in our governments and central banks? Some well-regarded economists argue that the Fed can print as much unbacked currency as it wants. As long as this money doesn’t find its way to the public, through loans made by financial intermediaries, they say it has no impact at all. The Fed and the other central banks are just “pushing on a string,” as the much-used metaphor goes.
This is a rather half-baked thesis, in my view. Carried to its logical conclusion, it would mean that countries without financial intermediaries would never face inflation, which is simply not the case. Such countries are usually very poor and the printing press has always been a major source of government revenue, and inflation. The technical term for this type of revenue comes from the Middle Ages: seigniorage. It describes a situation where only lords (in French, seigneurs) had the right to mint coins, which allowed them to profit from the difference between the face value and the intrinsic value of the coins.
In a similar vein, governments in very poor countries often use unbacked currency to pay their bills. This practice tends to erode confidence in the value of their currency and, thus, fuel inflation. In the developed world, when we read press reports that, “under quantitative easing, the Fed is buying US Treasuries,” it sounds like rather serious high finance, doesn’t it? In fact, it is good old seigniorage.
It comes wrapped in more complex terminology to hide the fact that things may no longer be quite under control. My view on the ongoing deflation/inflation debate is that, yes, due to various misperceptions, deflationary pressure may persist for a while yet. But in a world awash with unbacked currency, the inevitable outcome of running the printing presses is inflation. As Colonel Hannibal Smith, leader of the A-Team and played by the redoubtable Liam Neeson, tellingly says, “There is no Plan B.”
A couple of days ago, trapped in such a state of mind and body, I watched “The A-Team” on the in-flight entertainment panel. Thinly based on the formulaic hit TV series of the 1980s, there was plenty of good-guys-versus-bad-guys action and lots of pyrotechnical chase scenes. In the end, rest assured, the good guys win, and one of them even gets the girl. But what tickled my economist’s antennae was the storyline: The A-Team’s mission was to recover stolen plates used for printing US hundred-dollar bills. As their CIA handler put it, they had to get those plates back before some rogue element uses them to print “unbacked currency.” Sounds grave, doesn’t it?
Indeed, my reaction was, “So what?” Currency hasn’t been backed since the collapse of the Bretton Woods system in 1973. Until then, you could get a dollar’s worth of gold from the Federal Reserve for each dollar bill you turned in. Now, all you’re likely to get in exchange from the Fed is another dollar bill (and a puzzled look from the person behind the counter).
What actually supports a paper currency’s value? Nothing, it turns out, other than our steadfast belief that it is “worth” something. The entire, vast international monetary system is built upon this self-fulfilling confidence. Inflation – when a currency is losing its value – reflects waning confidence in that currency. This would logically mean that deflation’s lower prices indicate a currency has risen in value. In other words, our confidence in it as a store of value has increased.
But this is one of those times when logic and reality remain far apart. Economists have a useful term for describing how much money flows through an economy. They call it the monetary base. This refers to money in public circulation or in commercial bank deposits held at the central bank. Does the tidal wave of unbacked US dollars now flooding the monetary base of the US really reflect greater confidence in the dollar’s value? This amount has soared from 800 billion to a dizzying 2 trillion dollars since 2008.
Has the financial crisis really made us more confident in our governments and central banks? Some well-regarded economists argue that the Fed can print as much unbacked currency as it wants. As long as this money doesn’t find its way to the public, through loans made by financial intermediaries, they say it has no impact at all. The Fed and the other central banks are just “pushing on a string,” as the much-used metaphor goes.
This is a rather half-baked thesis, in my view. Carried to its logical conclusion, it would mean that countries without financial intermediaries would never face inflation, which is simply not the case. Such countries are usually very poor and the printing press has always been a major source of government revenue, and inflation. The technical term for this type of revenue comes from the Middle Ages: seigniorage. It describes a situation where only lords (in French, seigneurs) had the right to mint coins, which allowed them to profit from the difference between the face value and the intrinsic value of the coins.
In a similar vein, governments in very poor countries often use unbacked currency to pay their bills. This practice tends to erode confidence in the value of their currency and, thus, fuel inflation. In the developed world, when we read press reports that, “under quantitative easing, the Fed is buying US Treasuries,” it sounds like rather serious high finance, doesn’t it? In fact, it is good old seigniorage.
It comes wrapped in more complex terminology to hide the fact that things may no longer be quite under control. My view on the ongoing deflation/inflation debate is that, yes, due to various misperceptions, deflationary pressure may persist for a while yet. But in a world awash with unbacked currency, the inevitable outcome of running the printing presses is inflation. As Colonel Hannibal Smith, leader of the A-Team and played by the redoubtable Liam Neeson, tellingly says, “There is no Plan B.”
Friday, September 24, 2010
24/09/2010: Will that be one dip or two, or even more?
Finally, some good news: the US recession is over. According to 21st September’s announcement by the Business Cycle Dating Committee of the National Bureau of Economic Research, it apparently already ended back in June 2009, or didn't you notice?
At the least, we find the timing of this assessment rather odd, since one of the most hotly debated questions today is whether the US has already slid back into recession, into the famous double-dip.
There are no easy answers here. While some leading (forward-looking) indicators suggest a renewed recession scenario, others are still flashing the green light of growth. And for the nearly 10% of the US workforce that is unemployed, it must feel like the recession never even paused for breath.
But I think the double-dip debate could be missing the point. Let me explain: Over the past two years, I have not heard a single economist suggest that escaping the post-financial crisis recession would be easy in the US. Most observers have predicted a recovery that would be much slower than those following previous recessions. The reason: one of the traditional engines of growth, a flourishing housing market, would obviously be missing around this time.
Looking at the "shallow recession" of 2001-2002, it appeared that another jobless recovery was in the making. Moreover, the myth of the "flexible" US labor market, already questioned eight years ago, has been further undermined by the collapse of the housing market. In the recent past, an unemployed Californian, for example, readily moved to North Carolina for a job. Now, facing a big loss on the sale of his home, he will think twice before moving. And not only will his California house turn a loss; it will be tough to get a mortgage for a decent new home in North Carolina.
So, despite all the massive fiscal and monetary stimulus measures, given the role of house prices in the origins of the recession of 2008-2009, the slow recovery is unsurprising. But this is not the end of the story. I think that the financial crisis has done long-term, even permanent, damage to US trend growth. Some key numbers bear this sad thesis out. Before 2007, economists generally agreed that the US economy reliably grew by an average of 3 to 3.5% a year. After all, this level of growth had established itself over a quarter-century, since the 1980s – at least until late 2007.
That era of steady growth has come to a painful end, in my view. I would guess the financial crisis has probably cut growth by as much as 1 to 1.5%. Why? Three reasons: the relentless deleveraging of US households, tighter regulations on financial intermediaries and the ballooning US government debt.
In hindsight, I think we have to acknowledge that US growth between 2002 and 2007 was a sham, enabled only by the helium balloon of private debt. This is reflected in the US current account deficit, which had grown to almost 8% of GDP by 2007. And this was not the only imbalance: for years, the US simply consumed far more than it produced. Minus the surge in the current account deficit, a more sober estimate of US economic growth in the 2000s yields a figure closer to 2.5% than to 3%.
With US households now really starting to save in earnest – or, more precisely, to reduce their heady levels of debt – this illusory engine of growth is out of gas. The situation is only exacerbated by the extreme caution being exercised by financial intermediaries – the banks, insurers and other lenders. Whether due to tighter regulations or the need to repair their own distressed balance sheets, lending activity is tentative at best.
And there is yet one more arrow puncturing the US growth bubble: the government's various fiscal stimulus and bailout programs are pushing public debt to levels that threaten to choke off any real growth for a long, long time. This is the view expressed in a recent study by US economists Carmen Reinhart and Kenneth Rogoff, and it is hard to argue against it, in my view.
If the US only grows at 2%, instead of the previously assumed 3-3.5%, the double-dip discussion addresses only a part of the story of America's economic future. Such a modest level of growth makes slides into recessionary territory far easier than a growth rate of 3.5%. So instead of worrying about a double-dip, maybe we should focus more on the prospect of multiple dips in the future.
Friday, September 17, 2010
17/09/2010: The pride of apocalypse
The world is following economic developments with bated breath, looking for some sign of whether we are headed for a double-dip recession. A Swiss asset manager recently joined the debate: “No, there will be no double dip. It will be a lot worse. The world economy will soon go into an accelerated and precipitous decline which will make the 2007 to early 2009 downturn seem like a walk in the park.” The author claims that this correction could ultimately drag on for 100 years or more, swallowing up all the wealth generated since the industrial revolution. His conclusion: the situation is so dire that gold will become important “for wealth preservation purposes.”
These are truly unsettling predictions. The aftermath of the financial crisis sending us all the way back to where we were before the invention of the steam engine? But why stop there, perhaps we'll find ourselves at a point before the discovery of America, or before the fall of the Roman Empire. And with such a dark view, how do we know gold would be up to the task of buffering this destruction? A cattle ranch in Wyoming – with lots of guns – sounds like a safer alternative.
Moreover, 100 years is quite a long horizon for such uncertain claims. Even if this scenario comes to pass, the asset manager that conjured it up might not be around anymore to celebrate its prescience. I can't recall hearing about any medieval asset managers – with the exception of the Medici, of course. All joking aside, it seems far more likely that this dire warning will turn out to be wrong, just like every apocalyptic prophecy so far.
Why is it that these end-of-the-world stories continue to find such a strong foothold in the collective imagination? From John the Apostle to Robert Malthus, from Nostradamus to Oswald Spengler, from the ancient Mayas to the Club of Rome – doom and gloom simply fascinate us. Yet our contrary tendencies toward unwarranted optimism and overconfidence make clear answers elusive. Newlyweds expect their marriage to last a lifetime even though they are aware of the divorce statistics.
But overconfidence and excessive pessimism spring from the same source, although on the surface they certainly seem antithetical. Both draw their strength from the deadly sin that brought down the devil himself: pride. By a strange psychological twist, our fondness for apocalypse might be embedded in our vanity just as much as our inherent optimism. After all, what could make us more special than being part of the generation that sees the end of the world as we know it?
Whether we want to or not, at some point we all fall prey to this sense that we are special, standing out from the crowd. Unfortunately for our end-of-the-world scenario, these predictions have been around since the dawn of civilization and won't disappear anytime soon. Even from one generation to the next, we are inclined to complain that everything was better in the past and that young people have no respect – something Plato was already saying almost 2,500 years ago.
The post-financial crisis world is forcing us to sober conclusions indeed, but what we need now is careful analysis based on facts. Our current circumstances present challenges that may seem insurmountable at times – there is really no need to spread apocalyptic visions.
Friday, September 10, 2010
10/09/2010: A primer in postmodern economics
I recently read a research note written by a US bank’s chief economist, and it left me truly perplexed. My esteemed colleague examined the reported friction between board members at the Federal Reserve, paying particular attention to the tension said to exist between Fed Chairman Ben Bernanke and board members concerned about the long-term fallout from current US monetary policy.
His surprising conclusion was that if the Fed were to lose credibility, this would prompt an appreciation of the US dollar (yes, that’s right: an appreciation). I sent him an e-mail flagging this apparent error, but received an equally perplexing reply: “No, no, you read correctly: the less credible the Fed is, the more anxious market participants become and hence the more they will seek the dollar as a safe haven currency.” A discredited central bank as the catalyst for a strong currency – you must be kidding!
Surely this flies in the face of mainstream economic theory and its dearly held assumption that investors behave rationally. And yet, we must admit that the financial crisis has strained this model to the breaking point. Many other social sciences have been dismantling the concept of rationality for decades – you could say they have entered the postmodern age, where irrational thought and action are simply accepted as part of the landscape. Major postmodern thinkers, including late French philosopher Jacques Derrida, propose a worldview in which reason is no longer king. Is it time for economics to follow suit?
Without reason as our compass, we may start to fear that anything goes. But we would also do well to acknowledge that postmodernism seems particularly apt to describe behavior patterns seen during the crisis. Fads, fantasies and fashion have often played a more prominent role than dispassionate analysis based on facts. Fears and trends have followed all sorts of irrational trajectories.
If we concede that an element of irrationality helps drive the markets, have we declared economics scientifically bankrupt? The simple answer is no. But we do have to take another look at what we count as sound evidence when trying to make informed decisions about the future. It becomes crucial that we spot the risks stemming from irrationality in the markets, rather than placing blind faith in their rationality.
Economist John Maynard Keynes famously quipped that “the market can stay irrational longer than you can stay solvent.” Investors who don’t want to test this claim won’t speculate on rapidly rising interest rates just yet. But interest rates are indeed irrationally low – and governments have been on a wild spending spree – so investors must also resist the fashion for deflationism and those irrationally expensive government bonds.
Friday, August 27, 2010
27/08/2010: When the only surprise would be no surprise at all
Many people will recall the stirring words of Franklin Delano Roosevelt during the dark days of the Great Depression: "The only thing we have to fear is fear itself." This was a rallying call to sentiment in 1933, not a rational policy argument. Perhaps that's why we remember it today.
Indeed, Roosevelt's words contradict efficient market theory, which sees investors as thoroughly rational actors. We think FDR had a point: experience teaches that investors are driven at least as much by sentiments, fads and fears as by fundamentals.
And investor sentiment has plummeted lately. Despite an earning season that, on paper, looks solid enough, trading volumes on the equity markets have shriveled, as has risk appetite. After a ripple of relief following the worst of the European sovereign debt crisis, a sense of dread has returned to the markets as summer ends. And this is worrisome.
Macroeconomic developments are again the center of investors' focus, and the picture, especially for the US, is fairly grim. Between fears of a double dip, or even a slide into depression – which at least would justify the excessively low interest rates – and the prospect of reliving the 1994 bond market crash, a range of worse-case scenarios are competing for fulfillment.
And now many technical analysts are pointing to the formation of a "Hindenburg Omen," which is not an Expressionist movie from Fritz Lang, unfortunately, although the name alone makes one shudder. Nor does the term refer to the Prussian field marshal with the walrus moustache, spiked helmet and a most unloved place in history. It's worse than that, actually.
In fact, the technical analysts are referring to the Hindenburg disaster, the spectacular fire aboard a German dirigible that killed 36 people in Lakehurst, New Jersey, in 1937. The event was captured on film and reported live on radio to a shocked world. Today, when technical analysts note the emergence of several particular patterns, they use the Hindenburg Omen as a metaphor for a stock market bursting into flames.
Declaring the formation of a Hindenburg Omen relies on several arcane technical parameters and the designation is not without its critics. Market fundamentalists would dismiss it as yet more "chartist rubbish." They would argue that, given the good valuation that equities currently enjoy, investors should ignore the esoteric mumbo-jumbo of the techies. But if we have learned one thing lately, it is that investors as a whole are seldom coldly rational.
Some statisticians will grant that, yes, Hindenburg Omens have been spotted ahead of every major market correction over the past thirty years. However, the sample is too small to support an ironclad rule. And while many big market corrections may have been preceded by a Hindenburg Omen, not every Omen was followed by a sell-off. Skeptics will also accuse Hindenburg advocates of "data mining:" They spot a pattern and then, after the fact, they seek out only the numbers that confirm their hypothesis. And finally, the fundamentalists assert that the Hindenburg Omen cannot be explained theoretically, making it utterly useless for predictive purpose.
In my view, though, it would be unwise to simply dismiss such signs, however questionable they might be. Whether the Hindenburg Omen can be read in the charts or not, it is the stuff of real market nightmares. Tales of Hindenburg sightings, plus a little more bad macroeconomic news, could very well spark a market fireball. After all, irrational behavior is not only evident in rising markets; it is also at work when markets tumble.
So, doom-and-gloom seems again ready to guide market sentiment. Don’t get me wrong: I do not belittle the growing pessimism. While it may indeed be fed by technical smoke and mirrors, at least some investors may be prepared for the worst, which would be a welcome change from the recent past.
It is possible that, like the many "reasons" so freely cited to feed market exuberance, the phantasms of a Hindenburg Omen may evaporate in the cold light of experience. We sincerely hope they remain merely the feverish figments of a technical analyst's imagination.
At this stage in our hyperactive financial world, the biggest surprise this year could turn out to be the absence of any surprises at all.
Sunday, August 22, 2010
22/08/2010: Forget decoupling, this is fragmentation
Decoupling – the idea that some countries prosper while others flounder – has entered a new phase. After slowly gaining credibility between 2005 and 2007, the term was swept aside by the jitters of 2008, reappearing in mid-2009. Now, a new word describes global economic developments: fragmentation. It has disturbing implications for the Eurozone.
Decoupling refers to asynchronous business cycles across regions – in other words, when one economy grows while another stumbles. Early in the 2000s, the US appeared to set the rhythm for the global economy. As its growth rate moved, whether up or down, so did that of the rest of the world. Late in 2007, signs of US weakness started to emerge.
At first, both Europe and Southeast Asia seemed immune to America’s woes and the concept of “decoupling” was born. The term’s usefulness quickly faded when the 2008 financial crisis taught us that we’re all in this together. The clear message of the crisis was the interconnectedness in the global economy. No major country could escape the shock waves from an extreme event in the world’s largest economy. But decoupling returned in 2009, applied first to Southeast Asia, led by China, then to the commodity- exporting countries, and finally to the other export-oriented countries.
Now, with the first half year of 2010 behind us, decoupling has reached a new level altogether. While US growth faltered in the second quarter, fuelling worries about a possible double-dip and prompting calls for more government stimulus, Germany grew at a rather astonishing annualized rate of 9%, almost outpacing China. What’s going on here?
Decoupling, it seems, has advanced to a stage perhaps better called “fragmentation.” First, decoupling took place between regions; now it is taking place within them. In the Eurozone, Germany is currently clearly the outlier, with some other northern European countries – for example, the Netherlands and Finland – also faring well. France and Italy have had decent, if not outstanding, growth, while Spain, Portugal, and especially Greece – the triggers of the European sovereign debt crisis – are in recession or very close to it.
Most economists agree that Germany’s remarkable second-quarter growth will not be matched in the second half of the year. Nevertheless, we think fragmentation will only increase, with some worrisome consequences. Germany’s growth is export-driven, as is the case in some other northern European countries. Meanwhile, in France, Italy and southern Europe as a whole, growth, however modest, has been much more domestically driven. This does not bode at all well for the future of the Eurozone. The larger the disparities, the more the tensions among the different members will grow, further exposing the impotence of the European Central Bank’s monetary policy.
Just imagine that Germany continues to post robust growth numbers through year-end, raising inflation pressures in Europe’s core. How will the ECB tackle this issue if, at the same time, Europe’s periphery is mired in recession or even depression?
As admirable as Germany’s growth might be, it could sow the seeds of deepening discontent in all of Europe.Friday, August 13, 2010
13/08/2010: Houses have long shadows
Real estate may be one of the oldest assets around. It has a long history of manias and crashes and surely was at the core of the recent financial crisis. If another property bubble is building in China, it will have consequences for us all.
The bursting of the recent housing bubbles in the US, the UK and Spain is still being felt today, four years after markets peaked. For most of these recent victims, the markets haven’t even started to recover. Remembering Japan’s long hangover after its housing and real estate bubble burst in the late 1980s, we have to face facts: this latest crash could take decades to undo.
When they burst, real estate bubbles inflict particularly vicious damage to a country’s economy, gutting broad swathes of the population. Since they are often fueled by dramatic credit and monetary expansion, when prices do collapse and liquidity dries up, seemingly overnight, it can lead to widespread bankruptcies and crippled financial intermediaries. Nasty deflationary tendencies lurk in the wings, waiting to strike while the patient swoons. This is the big, ugly fear of many economists for the US today. A replay of Japan’s deflationary stagnation in the world’s largest economy is not a pretty picture to contemplate.
But if they are so dangerous, then why do housing bubbles occur in the first place? Why don’t government officials combat them in the early stages? A straightforward answer is that they are surprisingly difficult to spot. The current Federal Reserve president and his predecessor, Messrs. Bernanke and Greenspan, are highly accomplished economists and they both failed to spot the US housing bubble, even in late 2005, when prices were skyrocketing. Some would say they didn’t miss the house price bubble; rather, they willingly ignored it because it didn’t match their policies and worldviews. Other, more conspiratorial minds might suggest that they saw the bubble but naively assumed the costs of the cleanup, once it burst, were manageable.
We would argue that despite extreme price movements a real estate bubble can be hard to recognize. Consider China. A recent paper from the US National Bureau of Economic Research notes that Chinese house prices “increased by 140% since the first quarter of 2007 and by a record 41% (annualized) during the first quarter of 2010.” This is obviously an extreme increase. But there are some crucial differences between the housing bubble that inflated in the US (and elsewhere) earlier in the decade and China’s current housing market dynamic.
The price evolution in China’s property market stems from a shortage of supply rather than from excessive demand due to cheap credit, that is, leverage. While housing prices have risen substantially in the past years, so has average urban income. Moreover, according to the International Monetary Fund, the value of outstanding mortgages is only around 14% of GDP in China. This needs to be compared with 76% in the US or almost 90% in Australia. Most Chinese economists acknowledge pockets of excesses, especially in the fashionable cities like Beijing and Shanghai, but they usually also point to the fact that, in aggregate on a national level, property prices have moved in sync with the national income.
And there is another significant difference between the laissez-faire US during the past decade and China today: The Chinese government has so far been relatively vigilant, openly expressing concern about a potential property bubble and taking measures to reduce precisely the kind of credit growth that could fuel such a bubble.
Whether China will ultimately face a burst real estate bubble, with all its dreadful consequences; or whether the current price rally, which has lately slowed, merely reflects fundamentals, cannot yet be known. However, given our experiences with similar real estate market developments, we should at least monitor the situation closely and acknowledge it as yet another risk in our post-financial-crisis world.
Let’s be clear: if it were to transpire, a burst Chinese house price bubble would have serious global consequences that could threaten recovery in the still unsteady developed economies. The world has indeed become one big house, with many interconnected rooms. It casts some very long shadows.
Thursday, July 29, 2010
30/07/2010: The known, the unknown and what is unkown to be known
Former US Defense Secretary Donald Rumsfeld is surely a controversial character but no one will judge him to lack intelligence. One of his most famous quotes, while at a first glance quite obvious, is in fact rather profound: “There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don’t know. But there are also unknown unknowns. These are things we do not know we don’t know.”
It is those “unknown unknowns” that science philosopher and essayist Nassim Nicholas Taleb, was referring to, when he cornered his famous concept of a “Black Swan”: An event, which cannot be grasped before it occurs because it doesn’t fit in our framework of understanding the world. The 9/11 terrorist attacks were such an event.
Once a black swan event has occurred, there will be plenty of experts delivering an ex post story, explaining it, fitting it in our cognitive frame and making it look obvious and predictable in hindsight. Taleb calls this the narrative fallacy. Interesting enough, since Taleb has published his book, the black swan concept itself has become part of narrative fallacies. Many pundits, who didn’t see the financial crisis coming, are referring it now as a black swan event. By doing this, they are delivering at the same time a rather good excuse for their forecasting failure. “If the financial crisis was really an unknown unknown, you cannot blame me for not having foreseen it”, so goes the argument.
However, this is a rather lame defense, as the financial crisis was definitively not a black swan. Economists and experts could, and indeed should, have seen it coming. An explanation of why they didn’t, stems from the missing fourth possibility in the known-unknown square: the unknown known. Radical philosopher Slavoj Žižek introduced this concept in a critique of the US administration regarding the Iraq war but it can as easily apply to the behavior of the vast majority of us, economists, before the financial crisis.
Every element of the crisis was in plain sight: from the housing price bubbles to the alchemy of securitization, from the tremendous leverage in the financial sector to the immense international macroeconomic imbalances. Yet, only a handful of bright minds were able to put the pieces of the puzzle together and warn of the disaster’s imminence.
In my view, this blindness in front of the obvious has to do with the self-perception of the vast majority of economists as being hard scientists, which we are not. Many of us rely on models for the sake of their theoretical beauty despite having been proven wrong by reality, over and over again. This attitude can be summarized in “if the world doesn’t fit my theory, then the world must be wrong”.
Not many economists had Alan Greenspan’s courage after the financial crisis to humbly admit: “I found a flaw in the model that I perceived is the critical functioning that defines how the world works.” As I am writing this article, I am pretty sure that modern portfolio theory, value at risk and the efficient market hypothesis continue to be taught in academia as if the financial crisis never happened.
So where is the next unknown known? At least since David Hume and very likely earlier, we should know that wealth cannot be built through money printing or public consumption financed by debt creation. However, many economists today not only feign to ignore it but are even encouraging governments to pursue those dangerous policies. When in a couple of years from now, a new crisis hits in form of sovereign default, high inflation and currency debasement it won’t be a black swan but just a new manifestation of the unknown known in economic science.
Tuesday, July 27, 2010
27/07/2010: Chinese puzzles to stress you more
Amidst all the pontificating over the European bank stress tests, whose significance is rather less than advertised, a small news item went largely unnoticed.
But, in our view, this other story could well say more about the economic future than learning that a couple of ailing Spanish cajas failed their tests, to no one’s real surprise.
The French and the Germans have talked about it, but the Chinese actually did it: they launched a new, non-Anglo-American credit rating agency. Let that sink
in for a moment, please, because we are convinced that markets will be taking this new agency seriously in the not too distant future.
With Standard & Poors, Moody’s and Fitch downgrading the usual southern Europe’s suspects – Portugal, Greece and Spain – they have once again provided ample ammunition to their critiques, who liken them to pyromaniacs who join the fire department: they only downgrade a credit when it nears irrevocable default (and everyone already knows about it).
China’s new Dagong Global Credit Rating surveys more than fifty sovereign debt issuers. And it does so without taboos.
The US, with its supposedly riskless debt, gets an AA rating; the UK and France a mere AA-. Italy, Spain and Belgium are at A-; while Germany, Canada and the Netherlands fare better, receiving the same AA+ rating as China. The maximum rating, AAA, is only granted to Switzerland, Australia, Norway and a few other economically less important countries.
Of course, we can question the ideological intent of Dagong’s ratings. We can be reasonably sure that the political powers in China grant it little independence. But, however we judge its objectivity, we would be unwise to dismiss its ratings out of hand.
The new Chinese rating agency holds up a valuable mirror to Western countries. We need to acknowledge the real warts and blemishes it reveals. Within the next couple of years, given their current fiscal paths, the public debt-to-GDP ratios of US, France and, to a lesser degree, the UK, which has at least started to do something about it, are going to surpass the 100% threshold. This will surely spell the end to their precious AAA ratings at some point. The traditional rating agencies will have to downgrade their sovereign debt.
In this sense, we must acknowledge that Dagong is only anticipating the inevitable. We believe this is exactly what a rating agency is supposed to do. At least by this standard, Dagong seems more credible than the Big Three agencies. And given that China holds over a trillion US dollars in US debt, it is slightly astonishing that Dagong had the courage to downgrade the US and risk undermining China’s own massive US holdings.
To those who scoff at the idea that a Chinese agency could some day wield the same influence on the markets as the big three agencies should not forget one thing: Dagong is an agency of a creditor country, while Standard & Poors, Moody’s and Fitch all represent debtor countries. If you were lending money, who would you trust more, the self-assessment of the borrower, or your own judgment?
In our view, Dagong’s ratings are yet another small but significant step in the reshuffling of the global economic order. Slowly but surely the center of economic gravity is shifting from west to east, from developed to emerging countries.
After all, in the end, the one who pays always calls the tune.
Tuesday, July 20, 2010
20/07/2010: Contrarians: the modern market stoics
Lucius Annaeus Seneca the Younger (3 BC - 65 AD) was one of those particularly Roman multi-talents. He was his era’s most renowned stoic philosopher as well as a distinguished playwright. He was also an advisor to Nero, who forced him to commit suicide when Seneca picked the wrong side in a plot to assassinate the emperor. In addition, Seneca was evidently an astute and very successful investor, amassing a considerable fortune.
Unfortunately, we know nothing about his investment philosophy. Back then, the wise and the wealthy were not writing airport bestsellers on how to get rich. They were focusing on more important moral issues. But we can find some hints in Seneca’s writings about how he saw the world and, hence, what might have been his investment strategy.
And we can also look to stoic philosophy for insights into Seneca’s investment philosophy. In his pamphlet, On the happy life, Seneca states “argumentum pessimi turba est,” which means, essentially, the mob’s favor is proof of the worst. This definitely sounds like the great thinker did not hold the view of the masses in high regard. Today, this would make Seneca a true contrarian.
Whether he was the first of his kind or merely pursuing a known investment strategy remains an open question. Nevertheless, it requires the considerable moral strength of a stoic to be a true contrarian. This stance does not conform; rather it rejects broadly held opinions. This can lead to painful social exclusion.
For some investors, being called a contrarian is high praise. Many aspire to the status but, in fact, fail to really achieve it, given that their investment behavior is actually rather conformist.
So what is a contrarian? A superficial definition would state that a contrarian investor always acts opposite to the crowd. However, this would imply that the crowd is always wrong and that might be too harsh a statement. In 1841 Scottish journalist Charles Mackay published his classic, Extraordinary Popular Delusions and the Madness of Crowds. But American journalist James Surowiecki ably countered in 2004 with his book The Wisdom of Crowds, where he makes a forceful argument in favor collective intelligence.
In our view, crowds can sometimes be right and sometimes be wrong. So if we accept this superficial definition of contrarian investing, it will sometimes be successful and sometimes not. We need a better definition and stoicism can help us here.
While it is commonly understood that stoicism calls for the repression of feelings and the endurance of pain without blinking, this is not what stoic philosophers like Seneca emphasized. For them, reason, discipline and clear judgment as well as inner calm was the way to conquer passion and emotionalism. Successful contemporary investors like Warren Buffet or Jeremy Grantham are commonly labeled contrarians. In fact, they surely are disciplined and resist following the latest investment fads or stories.
Hence, true contrarian investors do not merely resist the favor of the crowd. Nor are they so-called “perma-bears,” who always see the world through a pessimistic lens. Contrarian investors, like modern stoics, are simply dispassionate. They follow a line of reason when investing. Or, borrowing from another Stoic sage, Marcus Aurelius, successful investing is nothing other than “following right reason seriously, vigorously, calmly, without allowing anything else to distract you.”Friday, July 16, 2010
16/07/2010: Cephalonomics – An eight-armed lesson in survivorship bias
As an economist, I am sometimes assigned a rather low position on the evolutionary ladder. For example, I have been told that a dart-throwing monkey would beat most equity analysts at picking stocks. Now, after the World Cup, I've been downgraded a notch below a mollusk.
I admit it: I got clobbered by an octopus at forecasting who would win football’s World Cup.
Paul, the two-year-old cephalopod from Sea World in Oberhausen, Germany, correctly predicted the outcome of all eight World Cup games he was asked to forecast – seven involving Germany, plus the finals. If the odds of all the games were even – like a coin toss – picking the right winner eight times in the row would have a likelihood of 0.39%, or about roughly one in two hundred fifty. So Paul’s success edges toward the spectacular.
Now I don’t want to look like a bad loser. In fact, I greatly admire this sympathetic cuttlefish. After all, he’s a fellow soccer fan. But I do want to stress a couple caveats to his triumph.
For one thing, the set-up of Paul's prediction experiment left some room for spurious relationships. To indicate his call, Paul had to choose between two boxes of food, each bearing the flag of one of the contesting countries in a coming game. Some experts have argued that octopuses are attracted to the color yellow. Others, who think these eight-armed multi-taskers are colorblind, say they are more inclined to go for high-contrast designs. This would explain why Paul chose Germany, with its red, black and gold banner, in six instances but preferred Serbia and then Spain, whose flags are even more high-contrast.
Not being a marine biologist, and lacking any personal experience with the species beyond the dinner plate, I obviously cannot contribute much to this discussion. It remains a puzzle, though, why the team with the most highly contrasting flag colors would prevail over the quieter designs.
A second caveat relates to so-called “survivorship bias.” I am not referring here to Paul's own survival, although some German fans threatened to transform him into fried calamari after he predicted Spain’s semifinal win over Germany. Rather, I mean the attention, sometimes exaggerated, that is paid to a winner.
After he successfully called four games in a row, Paul started getting a lot of media attention. Leon, the porcupine at the Chemnitz Zoo, was wrong about Germany's first game and was promptly ignored. Mani, the parakeet of Singapore, correctly forecasted all the quarterfinals but after he erred on one of the semifinals and, unforgivably, the finals, he fell out of the headlines. If we took a worldwide survey, I am quite sure we would find many other animals that made wrong predictions. They simply got no press.
Survivorship bias refers to the logical error of reading too much into the stories of winners or survivors. Of course, it is usually only the survivors who live to tell their tale. But these narratives tend to ignore the experiences of the many others who did not survive. Over-emphasizing the tales of survivors can lead us to draw inaccurate conclusions.
This is especially important to bear in mind when it comes to investing. We tend to focus on our past investment successes. And even if luck might have been crucial, we look for more flattering explanations that reflect our skill and timing. In reality, this kind of selective narrative may not hold true in the future.
Again, my congratulations to Paul, who is now retiring. Since members of his species rarely live beyond three years, he won’t be back to haunt me in 2014, when the World Cup moves to Brazil. But I am already eagerly awaiting competition from Pedro the piranha, Sammy the snail and the rest of the forecasting fauna.
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