Crossing the Rubicon XI

Since the beginning of the year both the Portuguese and the Greek equity markets have been outstanding performers. In fact, the movement could be traced back to last summer spiking in the last month or so. Another indication of what is going on can be seen in the drastic reduction of the interest rate spreads between both these countries and German governmental bonds. Not only that, Spain, Italy or Ireland, albeit in less pronounced fashion, are all part of the same market movement. The local stock exchanges are boosting while spreads are narrowing and this is all part of the same package, an expectation that the economy of the periphery of Europe will support these asset prices.

There is a common misperception out there that stock exchange prices discount future events. This view is held mainly by people who do not act directly in the markets (namely politicians, but these only hold this view when markets are going up). The logic behind it is quite simple: if investors know something will happen tomorrow, they will act upon it today. With thousands of people closely monitoring what is happening it is only natural that the price at which a given share trades swiftly changes to incorporate (and provide) new information. The problem is that neither investors, nor nobody else for that matter, know what will happen tomorrow. So all the market actually coordinates is the present value of future expectations. The quality of those expectations influences the level to which those expectations will accurately match future events. Institutions are keen in shaping these expectations. Institutions play a fundamental part in reducing future uncertainty. They are benchmarks to how people are expected to behave. Increased market volatility could and often is a manifestation of decreased quality from the institutions backing market participants’ decisions.

What the recent price movements in the above countries tell us is that there is a preference for assets from these countries when compared to others. The conclusion is obvious, there is less perceived risk looming over these countries or, better still, the generalised expectation is that things will eventually work out well for them.  But what does “work out well” really means? It means investors expect those governments to service their debt and for the companies listed there to sell their products at profitable margins. From the investors who are buying those assets point of view it doesn’t really matter how this is achieved. It could either be that those economies will grow stronger or that someone is going to provide those countries with the necessary resources for those goals to be met. The general hope is a little bit of both. By helping those governments, the EU, the IMF and the ECB are hoping, in time, those countries can fend for themselves. But this is where I do not see how.

Greece is a mess. People are going back to the villages and to barter. There is a monetized economy subsidized by Europe that is government run or, at least, government dependent. High unemployment means people have to look elsewhere for means to attain their goals and that is what they are doing. The task of bringing these people back to the market economy could be facilitated by the fact that people would rather be in a monetized economy than to operate in its border. But the state-run economy of Greece has low productivity and capital goods are being withheld from more productive uses to service the system’s incumbent beneficiaries. There is no way the Troika can supervise the process of bringing unemployed people back to productive activities. Generally speaking because it cannot acquire the ability to do so, and particularly because it cannot circumvent the very same people that brought Greece to where it is now.

Portugal is not doing much better. Austerity there meant decreased deficits, and yet a deficit by definition means a nation is still spending more than it gathers in taxes.  The debt to GDP ratio is now somewhere north of 120% and, despite the fact no one expects that debt to be paid, servicing it alone is already a very heavy toll for the Portuguese highly taxed citizens. There is widespread dissatisfaction with the government, yet change means putting the previous ruling party back in charge. The private sector is also leveraged raising the total debt to GDP ratio to some staggering 350%. The country was never famous for its social services network yet, to make things worse, social benefits (that people believe they paid for) and pensions (that they most likely did pay for but were used to pay previous generations) are being cut (except for those lucky enough to work in the public sector, to whom most of those cuts were obviously deemed unconstitutional by civil-serving judges). Clever people are emigrating en masse, the number of those leaving the country being larger than the number of births (Did I say clever? I meant qualified, clever people, like rats off a ship, left a long time ago).

Spain seems a lot better than Portugal, except for the fact that the country is disintegrating. Catalonians, if not in their majority, at least the most politically-active members of society want to split from Madrid. This came to the point where the Catalonian local politicians will have to concede in order to disguise their own incompetence. For 30 years they’ve played the number of looking like they favoured independence while acting as a buffer to those same independent claims behind closed doors in exchange for a larger share of the Spanish state pie. If the Spanish treasury acts recklessly enough to guarantee the share of the national debt theoretically allocated to Catalonia like London seems to be doing, it will be a too good opportunity for Barcelona to miss. If Catalonia goes, the Basque Country would follow suit, the only excuse they lack is international recognition. They are too small to get it for themselves but if Catalonia gets it, their case would be a mere expedient. Even if the country remains united taxes have risen to Swedish levels, something that is very likely to reduce the possibility of increased tax exactions although the government is not deterred in is want to do so.

Where I’m trying to get at is that no one should put high hopes on economic miracles. This does not necessarily mean the promises made by asset prices from these countries will not come true. In Northern Italy (mainly Lombardy), their southern countrymen are commonly regarded as bloodsuckers thriving on their wealth. To some they are not even worthy of the rank of countryman, Italy’s southern border would only stretch as far as Tuscany, maybe Rome, everything lying beyond that point being part of Africa (presumably Libya).  On the other hand, the South of Italy complains the North is not providing them with enough resources to develop or, in a milder version the corrupt political class in Rome keeps all the money. And yet this state of affairs survived for the last 150 years. Similarly there is no end to the amount of money that can be spent by the government of Andalusia, Spain in infrastructures or social services to develop the local economy. The region remains at the bottom of most economic indicators. One is tempted to suspect they are not really trying. Maybe, just maybe, local rulers from both the origin and the destination of these transfers are better served by the current situation. This is why despite the fact I don’t understand what Germans have to gain with supporting their southern European neighbours I do not eschew the possibility that it will (continue) to happen.

Some supposed benefits from increased transfers within the UE might be successfully sold to the German public. The mighty German companies will export more into these countries, providing more jobs, or the country will attract talent from those depressed areas to perform the most productive jobs inside the union increasing the sustainability of the German social security schemes permanently threatened by one of the longest standing inverted population pyramids in the World, are recurrent arguments. The problem with these arguments is that it is impossible to perform economic calculations on the real value of these transfers for the society as a whole. Assumptions have to be made and that is where it starts to go wrong. Collectivists, even of the mildest sort, thrive on the impossibility of these calculations, but ironically, it is the very impossibility of performing economical calculations that prevents any collectivist organization of society. In Margaret Thatcher’s famous words: socialism ends when it runs out of other people’s money. Social engineering progresses by bending institutions to their notion of what goals they should aim (maximizing social output if we are to believe their benevolence) blind to the fact they are feeding uncertainty outside their narrow calculations. It will show where and when it is least expected. Riding the periphery convergence trade in its multiple guises is all very well if people know what they are getting into. If it is based in an expectation that the economic outlook is improving, then it is time to get out.

Irrational Exuberance!? On Whose Side!?

Yesterday I read the excerpts from a conversation Alan Greenspan had with Justin Fox that the later published in the HBR blog (http://blogs.hbr.org/2014/01/what-alan-greenspan-has-learned-since-2008/). The most remarkable thing is that, with hindsight, Greenspan questions the ability of the FED to stop a bubble once it is set in motion and also of forecasting when it will burst (even when they had 250 first-rate PhDs in Economics to perform the trick). One might be tempted to ask what does the FED do if it cannot perform these tasks, even more so when, Greenspan wonders, bubbles are very likely to appear as a result of the FED being so good at doing their job.

From what I understood, Greenspan’s storyline goes like this: 1) the FED does a wonderful job at forecasting (everything but stock exchange crashes obviously); 2) this allows them to stabilize the real side of the economy; 3) yet, the financial side grows confident, greed conquers fear and bubbles form; 4) nonetheless, empirical tests show that fear is stronger than greed, thus when fear takes over, crashes happen; 5) fortunately, these crashes affect mainly the financial side of the economy; 6) because changes in the market price of wealth have little to no impact in the growth of the economy, as is shown in the GDP figures that remain fairly stable even in the midst of financial crisis; 7) if investors were rational all the time, these crashes would not happen at all, because the market prices always recover (tell that to the Japanese).

It is hard to know where to start, so let us go from the beginning. The FED has two mandates: to stabilize price levels (at roughly 2% because empirical studies say that is where the economy maximizes its output) and to promote economic growth. How can they tell they are doing a good job? The first mandate is measured by the CPI and the second by the GDP. Now I wonder. Could it be that the fact that monetary policy is aiming at specific levels for these aggregates is simultaneously creating huge distortions in certain features of the economy that are left out of the data (such as asset prices and investment and financing decisions – current vs non-current assets, long vs current liabilities and leverage)? Could it be that the wonderful job they do at forecasting (t.i. achieving) specific goals in terms of CPI and GDP actually stabilizes all things those numbers mirror at the expense of everything else? Could it be then that the monetary policy that allows for those stable outcomes, in fact sets in motion a process that, quite rationally, attracts both investors and consumers into taking more and longer-termed debt? What I mean is, isn’t meddling with the price system causing people to see future demand where it does not exist and future prospects of wealth where it cannot be sustained?

Assuming the boom and bust cycle has little impact in the real side of the economy as is shown by the GDP is ignoring the quality of those GDP numbers. State tax revenues went down by over 10% in most countries and the only reason the GDP did not experience a contraction of similar magnitude is because central banks found a way of funding governments with the difference while bailing out the financial sector. From an accounting point of view it might seem the same if government is spending money in very unproductive things (while massively increasing their future liabilities) rather than letting individuals pursue their own ends, but it isn’t. It might look the same if low interest rates allow businesses to remain open even if they have inadequate capital structures and low productivity (more so if we consider they have to fund the state’s increased future liabilities at some point), within a rigid price structure that prevents productive factors (namely workers) from being put to profitable use, but it isn’t. We are not talking about downside effects in the financial side of the economy. If high and persistent unemployment is not a consequence to the real economy I don’t know what can be.

But all this happens because people (other than Greenspan I presume) are mostly irrational. If I build a model that says that people’s motivations are either greed or fear and measure these motivations by the thickness of tails in the stock market I will also empirically conclude that fear is stronger than greed. But if I measure greed and fear by the amount of time the market goes up or down I may very well reach the opposite conclusion. After all, if fear and greed are the only motivations then it is perfectly reasonable to assume that when the market is rising, even if moderately, the majority of investors are being greedy. That is the problem with models, if you torture data long enough it will confess to anything (and if you have 250 first-rate PhDs working on it wonderful things can be achieved). Could it be that the disproportion of the tails is a manifestation that the act of destruction is faster than the act of creation? Trust is a hard thing to build, and harder still are institutions. When they are in place they are, fortunately, hard things to break. They endure a lot of abuse. But when they disappear things crumble fast. I believe it was Reagan who said freedom is never more than a generation away from extinction. I belive it is the same for every human endeavour where other people’s cooperation is necessary, sometimes even less time is required.

On Rational Expectations

Today I came across Niels Jensen’s The Absolute Return Letter, via John Mauldin’s weekly newsletter Outside the Box. It is a very interesting piece of work that I definitely recommend everyone reading. You can find it here http://d21uq3hx4esec9.cloudfront.net/uploads/pdf/2013_12_03_OTB.pdf

Jensen argues that QE is a dangerous experiment and I couldn’t agree more. He says that it is inherently deflationary and, although I disagree, I know this is only due to a different definition of inflation. Yet, he starts by telling us that QE was the right call and it was only the extension of this program (QE2, QE3/4 and other non-standard measures) that turned it into something harmful, and this is where I cannot follow his argument. In fact I don’t seem to find one, just a conclusion from what some might consider empirical evidence.

According to Jensen, the first QE prevented the post-Lehman financial meltdown while sustaining economic growth in terms of GDP growth. Again it is not so much that I don’t agree QE managed those things (it seems I am only making it worse for myself) it is that those things are extremely overvalued. To make my point I would have to go through a lengthy, yet hopefully entertaining, process. So I will do that probably tomorrow.

Meanwhile, so I don’t leave you completely empty-handed I will just say something about the “rational expectation hypothesis”. Jenson, again correctly, mentions inflation expectations as an important part of price formation in interest rates (It is very hard not to agree with the man). He argues, or so the hypothesis leads to conclude, economic agents make rational decisions based on expectations, thus when central banks say they will keep interest rates low, economic agents postpone their borrowing decisions.

Far from me to want to imply economic agents act irrationally. If anything, I would defend the opposite: individuals cannot act but rationally. My problem with this hypothesis is that it implies that by acting rationally they would all act the same way, t.i. the “right way”, as if differences in cognition, quality of information, past experience, etc. would not make each agent unique and their responses to the same piece of isolated economic data diverse.

True a central bank stated policy works in a way to try to homogenize interest rate expectations, but one thing is what central bankers aim at and a very different thing is what they achieve. The postponement of borrowing due to the expectation of lower rates in the future would not, in theory, prevent borrowing from taking place. We all know computers go down in price or, alternatively, a new more powerful model comes and replaces the old one for the same price. In reality we do not know this, we have expectations that this will continue to happen in the foreseeable future. Yet everybody would rather achieve their goals sooner than later. Individuals possess a time preference that impels them to act to achieve their goals rather sooner than later. Having a computer today is worth more than having one in the future for people who value it as a means to achieve an end, or as an end in itself. Cheaper computers in the future do not prevent people from buying one today. Some people wait for a better or cheaper model but prices on the current models don’t go down until the arrival of the new model (and its wholesale price) is a near certainty.

To postpone a business opportunity today (that by some reason some seem to believe is ready to happen tomorrow) has an opportunity cost that must be taken into consideration. It has to be lower than the expected benefit accrued by those expected lower interest rates. It is a lot of expecting to do and uncertainty to endure. Some potential investors might be doing just that, but it is probably simpler and more accurate to assume no such business opportunities abound than to believe they are waiting for lower interest rates to be grabbed.

The Card Players

 If we take a random look at the economic stats of lately we can quite reasonably assume the global economy is on the rise again. Not only that, also the financial industry is hiring people and assets under management are growing, not only due to rising asset prices but also because money is coming back from deposits and other supposedly “safer” investments.

A month ago or so I read a long-term forecast that said the World GDP could rise to as much as 100 trillion in five to seven years time. I cannot disagree even because GDP is just a number and one to which governments around the world pledge significant resources. I sometimes find it hard to believe the amount of wealth that can be destroyed just to make that number rise by a couple of tenths. But then again, it is not their wealth to start with.

Well my question is not if we will reach that number but rather how much is deemed necessary, on average, in global growth of asset prices, for the combined GDP of world countries to reach 100 trillion y 5-7 years?

For the time being things look good, with QE’s excess liquidity being channeled to Paul Cézanne, Francis Bacon or Andy Warhol works of art. I must admit it is mighty clever of those art purchasers. They are acquiring unique pieces of human ingenuity by delivering a very large quantity of reproducible-at-will pieces of…well…digital bits and bytes. Those pieces, in turn, are backed by assets (namely debt) of dubious quality kept in central banks mainly to achieve the transfer of wealth from productive individuals to capital structures inadequately built to satisfy human needs (the worst of all, as we very well know, is called “the government”).

Paul Cézanne, The Card Players (1892/93), Private Collection of the Royal Family of Qatar. Acquired for 250 million dollars in 2011.

Paul Cézanne, The Card Players (1892/93), Private Collection of the Royal Family of Qatar. Acquired for 250 million dollars in 2011.

 

Not only those few fortunate investors can gaze at the excellence of those few works of magnificent art, but fine paintings come with the additional advantage of transportability.  They can be carried around and put to rest faraway from the greed of bureaucrats and politicians. Something digitalized property claims, also known as financial assets, cannot. Could it be a coincidence that the first country to replace the use of a piece of paper to signify ownership of financial assets for a central clearing entity that just transfers registrations of ownership was Nazi Germany?

But the best thing is Francis Bacon’s paintings and Andy Warhol’s photos, like common shares, have a zero percent weight in the CPI so we can all pretend nothing is going on.

The Funk Soul Brother

The other day I got to see this graph. I’m sorry I cannot say where it comes from but I got it in a e-mail that somebody sent to somebody who, in turn sent to somebody else. Over and over, so I’m afraid I cannot give due credit to the author.

S&P vs Balance sheet

Anyway, I believe the reality it describes is pretty much clear to everybody: ultimately the increase in Fed’s balance sheet is not only sustaining but also driving up equity prices. This is the helicopter theory at its best, the fundamentals behind the rally ever since March 2009.

In reality it is not such a clear cut deal. The Fed began its balance sheet expansion before equity markets did pick up. At first, most investors run for cover and prefered hard currency to uncertain ventures. It is only when they began to trust business as usual would find support that they gradually came back. But, what about now? (The funk soul brotha, right about now…)  Back they are, so how come the FED is not reversing their policy?

The answer is, of course, it can’t. I know there are talks of taper but talking is cheap. What the balance sheet expansion aims at is to make interest rates low enough to make any financial asset an attractive investment, irrespective of how low its productivity is in satisfying human needs. If leveraged the better. There is no turning back. Massive savings are now supporting expensive and hardly profitable capital structures. The largest and less productive of these is called “the government”.

I do not know if this is an intended or non-intended consequence of central bank policy (I suspect the later), but I do know that the only way for governments to keep their promises to creditors, voters and supporters alike is by exacting more resources, a.k.a. wealth, from their subjects in the future. Those wealth producers, in turn, will have less to go around with. Believing the possibility of creating virtually infinite amounts of money (more accurately money substitutes) equates to being able to almost infinitely increase capital is an illusion. It ignores the decreased quality of that specific capital good that is being “produced” in exponential amounts. The rally will continue for as much as the illusion that wealth is being produced is maintained. New ventures backed by promises of future wealth will be issued, while in reality capital is being destroyed/malinvested  throughout the whole process.

Crossing the Rubicon – VI

The Descent of Money

Some time ago I came up with a definition of money. Not that there is anything new or uncommonly brilliant about it. It’s just a reminder of what that, which is considered by many the root of all evil, is. So there goes:

Money is the outcome of a process of entrepreneurial discovery for solutions to the coordination problems of the division of labour: time and space mismatches between production and consumption.

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Crossing the Rubicon – V

How to turn a bad bank into something worse

When economic crisis hit Sweden back in the early 1990’s their government performed a restructuring of the financial system (and of the economy as a whole for that matter), so deep that the paradigm of welfare state became more market orientated than the countries that looked upon the Swedish model with reverence while their leaders cried not enough was being done to be like them. Swedish free-market defendants might object to this view as they still endure high taxes and government intervention but things are better not worse than elsewhere.
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Crossing the Rubicom – IV

Modern banking started in Italy in the early 15th Century. Pinpointing the moment is a bit arbitrary, especially since we know a banker had is head cut in Barcelona during the 13th century for not being able to return depositors’ money, the Templar Knights performed the services we associate with banking after the turn of the first millennium and Christ himself expelled from the Temple of Jerusalem the dedicated members of the profession. It can be argued that people have always lent and kept valuables for others thus banks satisfy perennial needs since the dawn of times.
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Crossing the Rubicon – III

Many years ago, more than I care to remember, I read a novel by Gabriel García Márquez called Chronicle of a Death Foretold (skip the rest of the paragraph if you do not wish to know how it ends, oh well, you are going to find out anyway). This is a story of a vengeance loudly proclaimed in a small town, where everybody knows two men are set to kill another but nobody seems to be able to tell it to the victim-to-be, who inevitably (or not, that is the whole point) gets killed.

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On EMH and CAPM

Piet Mondrian (1930), Composition II in Red, Blue and Yellow, Kunsthaus, Zurich, Switzerland.

Piet Mondrian (1930), Composition II in Red, Blue and Yellow, Kunsthaus, Zurich, Switzerland.

The financial theory put in motion to protect the fundamental investor from metaphysical efforts of chartists ended up rendering fundamental analysis useless. The professional investor being relegated to a diversification optimizer or a beta arbitrageur at best.