...Archive for March 2006

Bubbles and the bias against shorts

Keynes’ words have become one of the most tired clichés in finance. “The market can remain irrational for longer than you can remain solvent.” I can’t find date attached to the quotation, but since Keynes died in 1946, it’s a fair guess that he uttered those words at least 60 years ago. Yet, his words are just as true today as they were then. That, I claim, is a blot and a shame on the profession of finance.

Markets are human institutions, evolved and invented to serve an incredible social purpose. They collectively are tasked with deciding how we make use of all that is precious, so that we productively employ rather than squander our providence. The financial press often treats markets like sporting events, like a kind of casino, or a thermometer for the “economy”, like all kinds of things. But markets are not weather, nor idle wagers. They guide what people do and do not do. They determine what is built and created, and what is left merely imagined. Markets guide us in deciding whether to learn computer skills or carpentry skills, whether to drive or to walk to work, where we will live and whether or not to have children. Markets are mind, we are all neurons. We are also the fingers and toes that do their bidding, individually rebellious but statistically obedient.

Update History:
  • 31-Mar-2006, 5:08 a.m. EET: Miscellaneous small clean-ups, added sentence about how no means of profiting from identification of bubbles implies that bubbles can grow unrestrained.
  • 21-Apr-2006, 10:53 a.m. EET: Some small clean-ups, removed phrase “with very diverse portfolios shorting low-cash-flow instruments” in description of investors who can take advantage of positive asymmetries in shorting, because the sentence was too long and wordy.

Confessions of an underwater short

For the last year or so, my personal investment portfolio has been heavily, aggressively short US equities and the US dollar. It’s not working out for me so far. Both the dollar and US stocks have done fairly well, and I have significant unrealized losses, and am struggling a bit to cover my positions. I find that being short is an ethically interesting and challenging position. I find troubling my awareness that to some degree, I have a financial interest in bad things happening. A terrorist attack in Saudi Arabia leads to a spike in oil prices? Ka-ching. A hurricane in the Gulf? GM declares bankruptct? Ka-ching, ka-ching, ka-ching.

That makes me feel nasty, like some evil Gargamel plotting misery and mayhem from his castle keep. Really, I’m not. Like most people, I’d like for everything to work out for everybody. So how is it that I’ve put myself in a position I stand to profit from other peoples’ loss and misfortune? (And perhaps there is justice, the hand of God even, in the losses, rather than profits, I’ve made from the strategy.)

The idiocy of crowds and “contained inflation”

We live in an infinite-dimensional economy that is forever summarized by a one-dimensional statistics. Monetary policy is summed up in terms of a few numbers: short interest rates, long rates, CPI and its variations. It’s very easy to miss the obvious if one just looks at these numbers.

New York Fed President Tim Geithner, in a recent speech, pointed out the obvious: “Research at the Federal Reserve and outside suggests that the scale of foreign official accumulation of U.S. assets has put downward pressure on U.S. interest rates, with estimates of the effect ranging from small to quite significant.” In other words, the “federal funds rate” may be at historical neutral, but monetary policy is very loose, owing to the activity of (especially) foreign central banks.

If you look deeper than one-dimensional summaries, you can find the evidence: Despite high short rates, we have low long rates, the famous “conundrum”. Despite low-ish headline and “core” CPI, check out the detailed CPI report.

Choose any category that is heavy on untradable services, and compare. Over 12 months, food at home is up 2.4%, food away from home (more service intensive) is up 3.0%. Alcohol at home, up 1.5%; alcohol at bars and restaurants, up 3.5%. Housing is up 4.0% overall. “Household furnishings and operations” are up only 0.6%, but most of that category is tradable goods. Look at the domestic “household operations” part (maids, gardeners, movers), you’ll see it’s up fully 5%! Medical care? Up 4% over 12 months. Recreation? Only up 1.1% But recreation includes TVs, bicycles, etc. — tradable goods. Drill down to the domestic-service-intensive components: Pet services are up 4.5%, recreation services up 3.2%. Education is up 6.2%. Personal care services (hairdressers, etc.) are an outlier on the low-side of the service universe, up only 2.5%. But “Miscellaneous personal services” are up 3.2% overall, and more for most subcategories. (Don’t die! Funeral services are up 4.5%! If incentives really do matter, we’ll all be immortal soon.)

The pattern is quite clear. Whatever is exposed to global competition is cheap, with low or even negative price growth. (Apparel, television, appliances, etc.) Pull this stuff out of the equation, and you’ll see the traditional mark of an overloose monetary policy — inflation. Put it all together with Geithner’s and Brad Setser’s insights, and it is not so complicated a picture. Thanks to the behavior of foreign central banks, monetary policy is very loose, even with a historically “neutral-ish” US Fed Funds rate. The market-priced long-end of the yield curve is a more accurate gauge of effective liquidity than the controlled short end, which at best represents an intention. A loose monetary policy is creating inflation whenever dollar-paid Americans are producing the goods. But our “sophisticated capital markets” are mollified by “central tendencies” of CPI, PCE, in which the inflation is masked by low-priced imports. The same central bank behavior that creates the dollar liquidity creates artificially low prices (in the form of undervalued exchange rates) to help hide the inflation. The idiocy of crowds.

Adapted from a comment to a post of Brad Setser’s.

Debt Sequestration: Why Debt-to-GDP is not a reliable constraint

In a comment to a post of Brad Setser’s, DF challenges (perhaps rhetorically), “What is ‘too high’? [Debt-to-GDP is] now ‘higher’ than in 1929… Let us know, if you have a solution to keep the debt level in a permanent high plateau, or have the debt rise forever, or reduce debt level without any harm for the economy.”

I’m glad to oblige:

Sequester the debt. Let it be purchased by entities that are willing to roll it over forever, that will absolutely never sell or demand cash for the debt that they hold, and that will accept further debt in lieu of interest payments. Private actors seem unlikely candidates for permanent debt sequestration, they do want eventual cash flow from the assets they hold.

The quadruple whammy of a petrostate crisis

There are at least four very bad and mutually reinforcing effects an “event” in Saudi Arabia, any of the Gulf states, or even Iran, would have on the United States’ macroeconomy:

  1. The price of oil would jump, because of both the immediate supply disruption and an upping of the risk-premium owing to the fear that turmoil may spread to other oil producers.
  2. The United States’ trade deficit would sharply increase, driven by the cost of oil.
  3. Financing of the United States’ trade deficit would be reduced, as the recycling of oil funds into “petrodollars” is interrupted in the affected state or states. Increased petrodollar flow from other oil states due to high oil prices might or might not take up some of the slack.
  4. The US would face immediate, expensive security options, likely requiring the Administration to request large emergency funding packages, as for Hurricane Katrina and Iraq War. These would worsen both the Unied States fiscal and trade deficits.

In short, aside from the ugly politics and warfare, the nationalism and unrest that any Gulf state crisis would provoke, it’s hard to imagine anything more perfectly tuned to turn America’s worrisome but so far benign deficits into a debt-financing and balance-of-payments crisis. If such a scenario were to occur, a lot would depend upon the willingness of other states to underwrite some of the security costs and to step up to the plate in replacing lost petrodollar purchases of US assets. If China, Russia, Japan, Western Europe, and other Gulf states support the US position, and want the US to take its traditional lead role in security interventions, they could collectively ease much of the financial pain. If there is not strong support for America’s position during the crisis, surplus countries could worsen the pain by slowing purchases of US securities. (That the economies of these other countries would also be rocked by any American financing shortfall might not matter in the context of a “hot” geopolitical event.)

Note that the above scenario would largely hold for an Iran-related crisis. Iran is not a “petrodollar” country — they don’t peg their currency to the dollar or spend their oil wealth directly on US securities. But it is likely that much of Iran’s current account surplus indirectly finds its way to purchasing US debt. In the end, money from countries that save more than they consume or invest flows to the countries that consume and invest more than they save, even if that flow is indirect and intermediated. An interruption in flows from any major surplus country would affect the ease with which United States meets its huge need for external finance.

Update History:
  • 17-Mar-2006, 2:52 a.m. EET: Changed title from “The quadruple whammy of petrostate insecurity”.

China and the folly of positive real interest rates

Let’s start with the conclusion:

Claims that China is still a communist country are often dismissed as nothing more than a historical conceit of capitalism’s new Wild East. But maybe China really does represent a new and interesting take on communism. Using the old words, one might describe China as allowing the development of a small bourgeoisie, with its constant revolutions in production, while harnessing the arcane machinery of bourgeois financial institutions to nationalize much of the wealth produced by the proletariat. Expropriation via high finance is superior to taxation or outright nationalization, because it masks itself as a fact of nature, as something implicit to markets and currencies and banks. It also has the advantage of turning the bourgeoisie into an ally rather than an adversary of the confiscatory state. Since the bourgeoisie are financially sophisticated, they can avoid expropriation of returns by working outside the state-regulated money and banking system. Plus, the state uses part of the excess returns extracted from the proletariat to buy the support of the bourgeoisie, while the rest can be used to pursue national goals. At the moment, China’s currency policy captures much of the action: By subsidizing exports, it buys off the capitalists; by preventing Renminbi appreciation or deflation, it robs real returns from ordinary savers; and by encouraging development and increasing China’s economic and industrial power, it serves state interests and arguably the public good.

To see how I got here, read below the fold. I seem to recall it had something to do with ice cream.

Update History:
  • 17-Mar-2006, 4:26 a.m. EET: Changed “Wild West” to “Wild East”.

Casa Leon — Constanta, Romania Office Space

Office space. By far the nicest in Constanta. 208 square meters, brand new air conditioning and heating systems, original hardwood floors, three balconies with breathtaking views of the sea. Adjacent to Constanta’s largest business hotel (Hotel Ibis). 15 € / m2 / month. Contact swaldman@casaleon.ro or dial +40 723 602524.

Dollar Hegemony

There’s a funny irony in the whole “dollar hegemony” story one sometimes hears.

Going back to the closing of the gold window during Nixon administration, and even before that, the argument is that the West and Japan propped up the dollar as tribute to the emperor, in exchange for implied security guarantees. Foreigners were overpaying for “worthless paper”, and Charles De Gaulle may have hated that (espcially when Americans used the paper thus propped to buy up French firms), but they were spending to save a status quo threatened by Soviet domination. They were purchasing American military and economic strength, because they depended on a strong America. The United States wasn’t putting a gun to their heads to pay up. The Soviet Union was.

Now here’s China, the newest of US dollar purchasers. I’d argue that among other things, what China is purchasing with its overpayment for US securities is American military and economic weakness. China’s undervalued currency contributes to the “hollowing of smokestack America”, and a postindustrial United States, with disruptable global supply chains and limited capacity for vertically integrated domestic military production, is a less formidable rival than Rosie the Riveter’s America.

Please note that this is not an anti-China post. I don’t think that China’s currency policy is primarily driven by geopolitical rivalry, it is mostly about economics and development. I just think when the costs and benefits are summed, changes in the sectoral composition of America’s economy enter into the benefits column. Nor do I think this is condemnable on China’s part. In fact it is admirable. Managing geopolitical rivalries are part of what governments do. One ought not condemn the government that does its job well, but the one which for all its bluster manages its situation poorly.

This is cross-posted as a comment to a post of Brad Setser’s.

Fecundity Indexing: Childrearing and Public Pensions

This was originally a comment to a post on The Volokh Conspiracy. It’s resurrected here in response to a post by Shannon Love, and because I think this is really an important, if rather obvious, idea. [via Instapundit]

Public pension systems should offer tiered benefits explicitly contingent upon the number of children a couple has had, but with the extra benefits not kicking-in until at least 20 years after a child was born. Lots of variations on this theme are possible (extra benefits to parents of the educationally successful, etc.), though there is a slippery slope to overintrusive social engineering.

This idea has the advantage that it offers an incentive to reproduce that is likely to disproportionally affect those well prepared to raise a child. An impulsive teen whose failure to use birth control leads to a pregnancy is unlikely to be swayed in her choice of whether to have the child by an incentive 40 years distant. But a distant incentive may well affect the decision of successful couples, already socking away funds in their IRAs an 401-Ks, and whose decision to have very few children is related to conscientiousness in managing their finances.

Aside from addressing broad perverse incentives against childrearing, fecundity-indexed public pensions would help counter the growing insolvency of social insurance programs. Any private pension manager knows that it is important to match the assets and liabilities of her fund, in terms of both quantity and timing of payoff. A private pension manager buys bonds as long-term, liability matching assets. But with a social insurance programs, owing to their scales, financial assets may become meaningless. If a society fails to produce real assets sufficent to support the aged, any bonds the social insurance program has become claims on stale air. The real asset that social insurance programs rely on is productive young workers. A social insurance program that wants to match assets to its liabilities ought to be encouraging the reproduction of successful wealth creators.

Update History:
  • 11-Mar-2006, 12:15 p.m. EET: Reworked awkward first sentence of last paragraph.
  • 11-Mar-2006, 1:15 p.m. EET: Changed title from “Public Pensions and Childrearing: A Proposal”

Money, valuation, and financial innovation

Summary: I claim that financial innovation has coupled the real economy to asset valuations more tightly than in the past. This coupling results from an increase in the liquidity of many assets, which has led to genuine growth, and is mostly a good thing. But the downside is a much higher cost to errors and volatility in the valuation of assets, as asset write-downs feed directly into contractions of nominal GDP.

The argument is based on a thought-experiment substitute for traditional monetary aggregates, which I think yields useful insights (and is inspired by a conversation with HZ in the comments to a previous post).

If I were to make up Steve’s estimate of the money supply, it would look something like this…

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