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.

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.

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.”

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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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09/07/2010: The D-word will be with us for a while

The mood on the markets has definitively soured. The global economy just can't shake off its troubles. Last week's US labor market report surely didn't lift anyone's spirits, with its message that the business cycle of the world's largest economy remains fragile. Is a depression ahead?

At the least, the double-dip discussion has restarted. Commentators are gauging the prospects of a second recession within twenty-four months, which last happened in the US in the beginning of the 1980s. Some pundits are even conjuring up the specter of a full-fledged depression, talking about having a "1932 feeling." While we do not dispute that the latest economic data was surprisingly weak, we think care should be taken when using a potent word like "depression."

For example, in the three years between 1929 and 1932, the US unemployment rate shot from almost nil to 25%. This surge far outstrips current developments on the US labor market, where unemployment has risen from 4.5% three years ago to roughly 10% today.

There is no hard and fast line distinguishing a depression from a recession. The usual rule of thumb for a recession would be three consecutive quarters of negative GDP growth. A depression is often defined as three consecutive years of shrinking GDP. While this situation might occur in some peripheral European countries, especially those that are implementing tough austerity measures, no one is forecasting such contraction for the US economy.

Another rule-of-thumb definition for a depression is that GDP must fall by more than 10% from its previous peak. Again, some particularly hard-hit peripheral European countries may meet this criterion, but the US cannot be counted among them. At its deepest trough, in the second quarter 2009, US GDP was "only" 3.8% below its peak in the second quarter 2008.

This is the good news. There are also some decidedly less good developments. Consider the widely acknowledged view that, in the 1930s, the US and other countries slid from a steep recession into an abysmal depression because governments failed to act. Despite having the latitude and the means to do so, they stood mutely on the sidelines, employing neither monetary nor fiscal policy to reverse the downward economic spiral.

Over the past couple of years, only massive government intervention has kept the US and some other large, recession-battered economies from tumbling into a depression. This is about to change. Governments now appear far less willing and less able to intervene again. Hence, while the likelihood of a full-blown depression remains, in my view, negligible, the D-word will probably be on pundits' lips for a couple of more quarters.

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01/07/2010: Economic hubris dies hard

In 1874, at the age of seventeen, Max Planck began his studies at the University of Munich. His physics professor, Philipp von Jolly, attempted to discourage the future Nobel Prize-winner with the argument that, “in this field, almost everything is already discovered, and all that remains is to fill in a few holes.” Planck persisted.

In 1894, another future Nobel laureate, US physicist Albert A. Michelson, also expressed the view that there were no more fundamental discoveries to be made in physics. Quoting the eminent physicist, Lord Kelvin, Michelson remarked that, “The future truths of physical science are to be looked for in the sixth place of decimals.”

A short six years later, Lord Kelvin was forced to recant. He had to admit he saw “two clouds on the horizon” of theoretical physics. One was the challenge of calculating black-body (electromagnetic) radiation, solved a year later by Planck. The other was the famously failed Michelson-Morley experiment on the behavior of light. As it happened, these mere “clouds” heralded a revolution in physics that led the birth of quantum mechanics and relativity theory. Physics, it turned out, was not quite a closed book after all.

Economics is a much younger, softer science than physics. Despite this – or more likely because of it – economics is often prone to the “Jolly-Michelson-Kelvin” conceit that everything important has already been identified and explained.

In 1929, so-called “Classical” economic theory was triumphant. The astonishing stock market rally of the late 1920s did not inspire even a note of caution. Rather, it was taken as confirmation that all was right with the world. Indeed, in August 1929 one of the most renowned economists of the period, Irving Fisher, stated that, “The stock market has reached what seems to be a new permanent plateau.” Seven years and one Great Depression later, John Maynard Keynes published his “General Theory,” revolutionizing economic theory and practice for the next forty years.

In the early 1970s, the profession had another Jolly-Michelson-Kelvin moment, when US President Richard Nixon stated, “We are all Keynesians now,” a phrase already coined, although with some reservations, by economist Milton Friedman in the mid-1960s. Essentially Nixon meant that the anti-cyclical interventions of government in the economy, widely applied after the war, could continue to assure growth and prosperity.

All was well until several simultaneous forces exposed the limits Keynesian activism: the Bretton Woods system of fixed exchange rates collapsed, the 1970s oil shocks crippled the global economy, and a new phenomenon called “stagflation” (simultaneous high unemployment and inflation) emerged.

Once again economists had to reinvent themselves. By the early 1990s a new theoretical platform emerged for economists to stand on, one that can be defined as a Classical-Keynesian synthesis. Central bank policy was vital to this approach, which can be neatly summarized as inflation-targeting. Ben Bernanke, the current Fed President, co-authored a much-cited monograph on this subject in 1999, for example.

The economic environment seemed to confirm this new synthesis. In the twenty-five years between 1982 and 2007, the period now nostalgically called the Great Moderation, macroeconomic volatility was very low, with only two recessions in the US. Inflation was negligible and economic growth was relatively high, especially in the Anglo-Saxon countries.

And once again economists served up a Jolly-Michelson-Kelvin moment. In a speech in 2002 honoring Milton Friedman on his ninetieth birthday, Ben Bernanke, then a Federal Reserve governor, apologized for the mistakes the US central bank made in the 1930s: “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

And in 2003, economics Nobel Prize winner Robert Lucas, one of the most influential economists of the past thirty years, stated in his presidential address to the American Economic Association, “The problem of depressions has been solved. Macroeconomics should move on to other subjects.”

Finally, Olivier Blanchard, the current chief economist of the International Monetary Fund, a professor at MIT and perennially short-listed for the economics Nobel Prize, wrote a survey on the state of macroeconomic theory in 2007. His conclusion: “For a long while after the explosion of macroeconomics in the 1970s, the field looked like a battlefield. Over time, however, mainly because facts do not go away, a largely shared vision both of fluctuations and of methodology has emerged. [….] The state of macro is good.”

The 2008 financial crisis and its aftermath – which is still unfolding, with worrisome potential consequences – has once again left the dismal science of economics in shambles. So few of its practitioners saw this crisis coming that those who did can be described as statistical outliers.

“This time is different” have been called the four most expensive words in the English language. They also form the title of a compelling, if rather dully written, history of financial crises published last year by Carmen Reinhardt and Kenneth Rogoff. Given their track record, the second most expensive four-word sentence from economists is certainly, “Everything is under control.”

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