1995’s 1980 vs. 1999’s 1980 GDP Growth Rate?

Economist  – like everyone else – make a trade offs between cost and benefit; one would guess more often explicitly than is typical.  When someone is seen to be making a choice toward a simpler method they are too often attacked as immoral or stupid rather than simply trying to get a good estimate and move on with their lives.  These attack push people to defend vigorously (and improperly) any strategy/statement/method (the rhetorical strategy of if you never admit your wrong you never are is far too wide spread).  Why can’t we just admit all out process and thoughts are imperfect and then handle them appropriately?

Anyway…two of my favorite weakness in predictive economic studies are (1) closed formed math-ification/bastardization of models and (2) the ignoring of the second time dimension of time series data. 

I’ve blog before about the fact that we haven’t advance mathematics far enough to get past the Gaussian assumptions is most financial model.  I recently read (worth a read) MacKenzie’s ‘An Engine, Not A Camera’ and read some amusing quotes which seems to suggest that when Mandelbrot attacked the normal distribution by promoting Levy distributions.  It seemed to suggest that some people responded by saying we can’t use that; it would make all our old work useless.  Sorry; the ‘if I don’t look; it won’t be there’ defense doesn’t work (if your pursuing the truth – it may work if your pursuing human recognition).  Although niether goes throwing out the good in pursuit of the perfect. 

The second problem which is what I would like to bring up here is that of PIT (point in time) data.  Many economist and financial analysis use time series to test their theories about how the future will look like.  Many appropriately lag the time series input variable because they know they don’t have the inputs in real time (you don’t have 4th quarter GDP until later in the 1st quarter of the next year).  But what is very-very rarely done (When ever I have argued that this should be incorporated I have been meet with cynicism) is that time series change over time.  As time passes they will revise the initial report to a final estimate and may revise it again if they receive new information.  Thus if you only lag the data you have a decreasing factor of foreknowledge in your analysis.  (Meaning in 1990 you have all the revisions for 1985, most of the revisions for 1988 and only the first revision for 1989).   The Fedearl Reserve has done good work creating this data. 

Now simply using a PIT series is not simply using the data that have at the time you would have had it.  What data should be used is a function of the reason for the revision.  If the revision is due to a methodological change then you should (ideally) use the underlying data available at each point in time to create a point in time data series based on the current methodology; if the revision is due to new information (not a methodological change) then you should use the PIT series as is.  Now I think it is right in many situation not to create or use PIT data (often you simply don’t have it) because it can be costly (time and money); but if you don’t take it into consideration at least consider cutting the confidence implied in the model.

Farmer’s new profession

I’ve been told that my post are depressing by a friend and thus I’ll share something humorous (you’ll soon want me going back to to depressing).  I noticed the stats on the Farm systems balance sheet and the thought crossed my mind that the American farmer could set up shop as a consultant on Wall-Street in order to educate the suited men on what a un-leveraged balance sheet look like. 

The interesting thing here is given that agro-commodities (the output of farm) are so much more volatile than banks products it illustrates the reality of the Minsky cycle; in that if volatility goes down firms leverage up so that the risk is the same (or is perceived to be the same) and if volatility goes up firms leverage down.  Thus level of volatility tells us very little about the riskiness of a sector or country without knowing the embedded leverage.

Brady’s Gift to The Emerging World

Many of us are familiar with the Brady Plan.  The idea was to convert loans owed by Latin American countries to major banks into bonds.  This would removed those loans from the banks book and start facilitating a working out process.  (Yes another banking crisis).  Well I was working around with debt issuance data and noticed that if you look at the outstanding bond debt of the emerging world it looks like the Brady plan not only help provide a means to work out the banks debt but also brought the developing world forward in terms of their access to markets, in that the amount of subsequent debt they were able to issue was larger than one would have excepted given the previous growth trend.  This makes sense to a degree in that once you have a certain amount of bonds you will achieved initial velocity…meaning their is likely someone is analysing it, likely a two way market for the debt and the infrastructure is there to facility the demand, so you – as a creditor – are now enabled to borrow more.  Another possible reason would be that the issues were big enough to deploy meaningful amounts of capital and thus attracted institutional investors.  Another plausible explanation would be that the Brady debt allowed developing countries to prove their creditability and thus gain acceptance to the bond markets.  This seems to jive with the fact that debt didn’t grow much during 91/92 (although it was positive) after the Brady jump in ‘90 (they worked off the old crisis), but then grows rapidly after ‘93. 

Let me explain the chart.  The blue line is the actual level of outstanding developing market debt; the red line is the level of debt before the Brady plan year grown by the historical growth rate (it eventually passes the blue line but that is not the point, of course growth will slow as the level gets higher…); the point is that the developing bond market got a jump start from the Brady issuance and thus became a market much faster than it would have otherwise.  If we say that 200 billion is the measure of a true market then it got their in ~94 but wouldn’t have gotten their until ~99 without Brady. 

Is this good or bad?  This is a cursory observations and not a vigorous analysis so who knows but it raises some interesting questions.  It seems good in the sense that capital could be deployed and that credit became more liquid but where these countries ready for capital markets (yes they were having petrol dollar sent their way via the banks before this) but did they have the financial system infrastructure to handle more capital inflows?  Did these markets encourage greater economic problems down the road?  Likely a mix of both and – depending on the country – I suspect a different answer would emerge but I think it is interesting to see how the Brady plan jump started the developing world debt markets.

Implied Nationalization

With all the talk of late about the chance that the banking system will be nationalized (in the UK more so than in the US) I started to play around with the idea of backing out the implied probability of nationalization from market pricing.  Now this is a doable feat but the require assumptions are so numerous that the ending implied probability of nationalization is – in my view - more  fantasy than reality but the exercise is fun anyway. 

First I tried to play around with the idea that if I treated the stock as an option and the market cap as the price of the option if I could back out the underlying value.  The underlying value in this this case is the company or more specifically what what someone would have to pay someone to take on the company if they did not have limited liability (so it can be negative).  Another path that one could take would be to start with that company ‘true value’ and work forwards to an option value of the company which can be compared against the actual market cap and thus give you a ‘implied nationalization’ rate.  This should give an answer to the question of how likely is it that the bank is nationalized and as an equity holder that I get nothing back.  First off this is not a trivial exercise.  First the classic black sholes option model can’t be used because it uses a log normal distribution (no negative values for a underlying asset).  Thus a different distribution has to be inserted into the equations; such as the typically Gaussian normal distribution.  This allows for the exercises proposed above (of course this requires to estimate a volatility estimates which encapsulates the discrete nationalization risk and the future path of the banking sector; good luck). 

Or…..you can take the easy way out and use a tree model to estimate the implied nationalization risk.  This will take a spoon full of sugar but take the following assumptions about Citi (for example and ignore the breakup).  In 5 years (1) They have a 2 trillion balance sheet, (2) they are earning 1.25% ROA (return on assets) for a annual earning of 25 billion, (3) discount the earning at 15% discount rate for a market cap of 167 billion and (4) present value that market cap back to today at a 30% rate; thus a 45 billion dollar market cap.  Compared this with the 19 billion dollar market cap that Citi currently has.  If we assume that the future holds only two paths (completely unrealistic it is quite likely that it is a combination of these too…recapitalization and large government ownership);  first path of nationalization and no equity return and a second path of return to normalcy.  This implies a roughly 58% chance of nationalization and a 42% chance of a return.  Now these estimates are all sensitive to the assumptions but it gives a picture.  Like I said above…the very likely path is massive dilution and eventually return to normalcy which is sort of a in-between path.

Did Geithnier start opening Pandora’s box of populist rhetoric?

The Bush administration or maybe more correctly the Paulson treasury used a rhetorical breeze through meetings of collaborations to urge the Chinese to move their currency toward economic equilibrium and thus easy the pressure of global imbalances.  Who knows whether this was helpful or not.  Would the fx had appreciated more or less if this encouragement didn’t happen.  In what form could we have been more forceful in demanding a solution to the global imbalances before they sunk our economic well being?  In my view public pressure on the Chinese is likely to backfire because they do not want to appear subservient to the United States.  Showing them why – although I suspect they already know – they need to adjust the currency (inflationary pressures, global imbalances) may be helpful.  As well as providing advice about a transition to a robust financial system (do we have any credibility here?). 

 

The Obama administration has quickly taken a more aggressive approach – whether this is in light of the continued large surpluses or the fact that the RMB has re-pegged to the dollar or some other reason is unclear.  This was brought into focus with Tim Geithner’s comment that ‘China is manipulating its currency.’  China didn’t take kindly to this.  I’m a little nervous about a more aggressive strategy.  It will embolden trade protectionist and its not clear to me that it will improve our chances of getting China to move it currency.  The best we can do is to adapt our fiscal situation and financial system to better handle the barrage of capital that is being sent our way. 

 

Interesting enough the last Democratic president took a similar approach to another eastern power about 15 years ago.  Japan was running significant at the time – 120 billion – trade surplus with the world in 1993 of which 60 billion was with the United States.  When talks about the bilateral imbalance stumbled comments about the problems of a weak yen emerged.  Clinton said, “there could be reasons other than closed-market policies for the lack of progress — no domestic demand, changes in exchange rates, inadequate efforts by Americans, not competitive products or services (2/11/1994)” when describing why Japan may have the surplus.  This comment was read by the markets as being negative for the dollar; bond yields rose and the yen rallied.  See the following chart for the Yen rally after the executive branch rhetoric (admittedly the massive surplus is a economic reason for the yen to rally but the 1990s were not a time of stellar economic growth in Japan).  So the very soft rhetoric worked – in large part because market participants believe that unless the Yen rallied the US would do something. 

 

 

So could the rhetoric work again except this time on China?  I’m doubtful.  First the RMB (chinese currncy) is effectively pegged; the Yen was floating – even if the BOJ would step into the fx market from time to time; thus it is not easy for the markets to do the adjustment for us (not that any spare risk capital is floating around could do the job anyway).  Hot money is already coming out (it seems like) not into China and given the state of the financial market deleveraging this seems likely to continue for some time…so sterilized fx intervention is getting easier not harder.   Second no country likes being told what to do; China especially.  I doubt they are going to take instructions from the US.  Even if we offer advice any subsequent action will need to look like it was their own.  Now if we step up the pressure via trade sanction we are shooting ourselves; demand for treasuries would fall and the world trading system – already in free fall – would become chaotic.  I suspect they would call out bluff…one of which I’m not sure we could back down from.  Did Geithnier start opening Pandora populist rhetoric?  I hope not. 

Independant Central Bank

Creating rules of the game such that the game ends up playing out the way that you want is something I tend to repeatedly harp on.  The political independence of a central bank is well recognized as a beneficial thing and the U.S. Federal Reserve is set up to protect its independence.  It is self financing and each year send back to the treasury a health check of excess profits; 34.9 billion in 2009.  This ‘profitablitiy’ - admittedly most of it is coming from interest on treasury bonds – will be weakened because the the fed is now paying interest on reserve; although I don’t think this will risk needing congressional financing.  What may risk the need for legislative financing is massive losses on its investment…in this arena we are in a wait and see place.  The structure as the board is also designed to prevent any administration from being able to dominate it.  There are seven members on the board, there terms are 14 years and the terms begin every two years.  This seems like it would keep the Fed Board insulated….but the board currently only have 4 members and Kroszner has announced his retirement.  Thus if the president can get his appointment through the legislature (seems likely) he would have a board that could be in his pocket.  Not what one would hope for.  With this structural risk in mind it is encouraging to note that Obama approach to appointments doesn’t seem dogmatic and Paul V. has his ear.  Its hard to imagine him being any where near a politicization of the Fed Board.

Fiscal Stimulus: A Panacea?

I’d like to respond to the view that the upcoming fiscal stimulus will be a panacea.  It’s not.  If you’ve been under the impression that Obama will push through a stimulus bill and magically the 3 million (ever increasing) number of jobs that he will createwill appear; your going to be disappointed.  Fiscal stimulus are – in my view – typically poorly done.  They are done two slowly, they are politically driven and thus mis the right target, and they have policy residue that gums up the system.  This is the exact opposite of what fiscal stimulus should be: timely, well-targeted and temporary. 

My second reason that my initial response to a fiscal stimulus is skepticism is where does the money come from.  If the government borrows dollars they are taking that cash from some where so the spending is being transformed (for example transformed from private to public expenditure) not purely created.  In certain circumstances this transformation can be beneifitical.   

If you didn’t see by now, in general, my response is that a fiscal stimulus is a short term gain for long term pain.  Or in short not worth it. 

In some circumstances a fiscal stimulus does make sense.  When a shock to the economy has prevented the system from transitioning over time and the paradox of thift has engaged, a fiscal stimulus can maintain aggregate demand while the system adjust.  This does not change the fact that fiscal stimulus can do structural damage to the system and are typically taken advantage by politician but in this case it is likely to be worth it that risk. 

But a fiscal stimulus will only hold us over until private demand is restored.  Unless we are willing to dramatically restructure the way our society works (with the government doing our spending for us) the fiscal stimulus must be a temporary band-aid.  What will restore private demand is a functioning credit system and restored household balance sheets.  The fiscal stimulus can help improve household balance sheet by providing jobs while those families deleverage and pay off debt.  The fiscal stimulus can provide some time for the banks to right themselves but we should not wait for the earning to recap the banks.  A greater recapitalization is needed to bring the system back on line.  This point was highlighted by Chairman Bernanke a few days ago.

Lack of Ability or Lack of Willingness?

Ecuador defaulted on its external government debt on December 15th.  It was decried by Curtis Mewbourne of Pimco as an unusually occurrence of default based on lack of willingness rather than lack of ability because the bill was a 30 million dollar coupon payment and the country has 5 billion in reserves.  Now he may be right but I’d like to consider why his presentation is too simplistic.  He suggests that the perceived cost of a default (loss of access to the market) had gone down because they had already lost access.  This is true but it is not clear to me that Ecuador had much market access to begin with and certainty wasn’t going to build the need credibility for future access through default. 

What about the existing debt stock?  From a quick scan on my Bloomberg I see about 6 billion in outstanding debt much of it due more than 10 years into the future.  From this perspective with billions in reserves the case for willingness over ability seems very plausible.  Curtis then goes on to talk about fx policy and the significance of the federal reserve swap lines to some emerging markets for $ debt and although I agree with him on that he moved on from the Ecuador story before it was over.  Ecuador is a dollarized country.  They have no local currency so the ~5 billion in reserve is not just to pay dollar debt and pay for import but also is the money need to be the lender of last resort in the banking system and a sharp decrease in the dollar reserves could ignite a run on the banks which would require those reserves. 

Ecuador may have look at the path of reserves and said to themselves, ‘we are going to default eventually because the deleveraging cycle is not going to turn around any time soon and thus our export value is not going to recover.  It would be better to default now (and dance with some rhetoric about the illegitimacy of the debt) and have some money to back the banking system than send out our remaining reserves igniting a banking system crisis and then have no dollars to fight it.’  So at least to me it is not clear at all that the Ecuadorian default was purely of the lack of willingness…but rather a future lack of ability. 

Political Transition

Tuesday’s executive branch power transition is a powerful example of the robustness of our society.  It doesn’t strike the typical American that the transition of power in a peaceful and organized way is not only extremely beneficial and it is not normal.  

It is easy to see why transitions in power can lead to problems.  When the power is lost by it prior holder and is floating to find a new home the nation is at risk from opportunistic foreign attacks as well as domestic disturbances (in both cases ask yourself who coordinates the response) but if the rules of the transition are understood power the risk of foreign or domestic groups trying to take advantage of transition less.  Consider czarist Russia went through centuries of destabilizing power transitions until Paul I established a transition law laying out the way in which power would be transfer (male Romanov succession).  Although his motives (ensuring his own power and out of distaste for his mother) were not in line with creating a stable or just society he resulted in at least creating a more stable one.  I don’t know if these rules where ingrained in the ethos of Russian society but it created enough momentum to create peaceful power transitions till the time of the Russian Revolution over 100 years latter.  The rules for U.S. power transitions are ingrained in U.S. ethos but are not ideal: consider the fact that the upcoming fiscal stimulus has basically been put on hold which is clearly less than ideal.  In fact the transition between Hoover and FDR during the great depression was call the ‘the interregnum of despair’ and the idea was floated to have FDR become secretary of state and have the president and vice-president resign so that FDR could get into power more quickly. 

You might quickly realize that a democracy that chooses who it wants as its leader every 4 years has a much larger number of transitions than a dictatorship (think Cuba’s Castro has lived through Kennedy, Johnson, Nixon, Ford, Carter, Reagan, Bush, Clinton, Bush, ~Obama…) but the incremental risk of transition doesn’t outweigh one of the major benefits of democracy; the benefit of structure revolution.  In the same way that power transition rules lead to stability in a country a democracy gives a set of governing rules which allow for peaceful revolutions.  Consider if GW was not subject to a term limit or an electoral boot?  Even though he is thoroughly unpopular would it be worth the cost of a revolution to remove him from executive power?  That is very unclear to me; what is clear is that the fact that the U.S. people can remove him and his party through a organized method is vastly beneficial.

Regulation: How to write rules

A G30 committee recently released a report highlighting the need for financial regulation reform.  I tend to agree with a number of the points although in line with expectations for a high level report its recommendation lack a degree of concreteness that one might wish for.  They want to make decisions about who is on the inside of financial regulation explicitly rather than a product of status quo.  This comes along with the recommendation that the regulatory should be centralized.  They suggest that their should be a robust framework for financial firms failure and the some systemically significant a firm is the tighter the regulatory should be.  They even had a reasonable framework for how to define systemically significant: F(ss) = (Size, Leverage, Interconnectednessss, Significance of services).  Other recommendations included greater transparency (ala a 10-k for structured financial products).  This quick overview I tend to agree with.  Two recommendation which although I don’t disagree I think missed the target a little bit are (1) update FVA (fair value accounting) account to prevent illiquid assets from causing a problem and (2) realign the incentives of the CRA (credit rating agencies).  FVA is a language and it provides information, hiding information about the value of the business strikes me as incorrect.  Having capital and funding bases which are match (so they can’t run) seems to be correct.  Although being able to write down you liabilities is foolish (you still have to pay back on par); that rule should be changed.  CRA’s quasi regulatory role should be eliminated and policy should discourage the correlation of analysis not encourage it.

If I’m going to criticize I figure I should share my own thoughts on regulation which I wrote a few months back. 

                                                                                                                                                                                                                          

Meta Regulation: Make the Rules Work

We have never relied on the benevolence of Smith’s butcher, brewer or baker but rather their self interest for our dinner.  This is well understood and acknowledged, what is less noticed is the condition, ‘In civilized society.’   It is the rules of the game that ensure that self love benefits the society, without which my money would be on the butcher. 

 Some parts of the financial system have operated in what, we now see, is an uncivilized environment.  How did we get here when we have thousands of pages of financial regulation and numerous regulatory agencies?  We had defined the goal.  The Federal Reserve is tasks with maintaining ‘the stability of the financial system and containing systemic risk that may arise in financial markets’ the FDIC with ‘the stability and public confidence in the nation’s financial system,’ the highest level goal being to encourage robust and strong economic growth.   

 Nietzsche wrote ‘the most common form of human stupidity is forgetting what one is trying to do.’  The most common ways in which he is affirmed is by actors narrowing their focus on a specific detail while forgetting to connect it to the goal and questioning if it does not. The FDIC, Fed, and other agencies were lost in the details, confused by territorial and authority concerns, and in the process, amidst the great moderation, forgot what they were trying to do.  Out of which grew the shadow banking system which operated outside of civil society.  One major area that existed in the shadows was securitization.  The simple way it worked was that a firm would issue loans, bundle them and then sell them, all of their profits came from the issue not the quality of the product.  Without civil society ensuring honesty within this process it ended in significant amounts of fraud; not only of the type where borrowers falsified income but also when the securities were resold. 

Thus we find ourselves on a path to recreate the financial regulatory framework.  When we construct a new regulatory framework we must not forget what we are trying to do.  So far we must hope that the proposals coming out of Washington, such as capping executive pay, are more rhetoric than the principals as they do not accomplish the goal.  We need to construct rules which give us the result we wish (reminder: a financial system that ensures robust and strong economic growth).  The goal is not to punish the butcher however just that may be.  We need to focus on creating a rule set that establishes civil society, that get the butcher, brewer and baker self interest in line with the goal.  For example why is democracy the best of a series of bad set of rules to organize governments?  It is not that it produces the best policies, it is very unlikely to do, that but that it institutionalizes revolution such that liberty can be preserved without spilling the blood of patriots and tyrants to the disappoint to Jefferson but to profit of all those whose blood was not spilt.  If institutionalizing revolution is the key to democracy’s success what is the key to a solid financial infrastructure?  Aligning fundamental economic motivations with profit motivation and creating an acceptable framework for failure that covers the entire financial system while charging the insured entities. 

To provide some details on how to accomplish this.  First eliminate the confusion about whose responsibility financial regulation is.  The past few decades have dramatically reduced, if not eliminated, the real differences between all financial entities.  Insurance companies, banks, private equity, hedge funds, and other financial entities are all in the same business but with different strategies.  They need to be subjected to the same conceptual framework for regulation.  Second empower the regulator to fill in loopholes by focusing the guidelines on conceptual goals not rules.  Importantly ensure a complete failure framework; non financial firms have Ch11, FDIC regulated banks have FDIC receivership, but there are still financial firms that do not have a framework for failure (or at least not an acceptable framework, as seen by the result of Lehman’s Ch11).  Lastly encourage robust pools of capital.  We want to create rules that make the best move a fundamental economic one not a slight of hand trick.  Encourage and reward well designed risk management not financial shuffling or accounting trick meant to hide excess leverage.  This is not simple but for example the fact that the unregulated banking was experiencing a funding run and it had no lender of last resort or deposit insurance, create a one sided trade.  Trader could pull their account from an institution and at the same time short the stock (and stopping shorting is not the answer, anyway it is far too easy to get around).   These actions were not necessarily fundamentally economic but were profit motivated and firms have a fiduciary responsibility to their client to act in the way they did.  If we can align traders and fundamentals, one piece of which is to create a robust process for failure, we will move closer towards the financial civil society where the hedge fund, private equity, and  investment banking billionaires’ will be working for me in much the same way as the butcher, brewer, and baker.