Business Press

I’ve written before about the problems of a singular ‘you must predict’ the future mindset in the media. With that mindset in hand I was reading CJR (Columbia Journalism Review) recent cover story ‘Power Problem’about how the business press failed to challenge the institutions that brought down the financial system.  Now if I ignore the fact that I think the author misunderstand the roots of the crisis (which I would argue are global imbalance not the US financial system…the US financial system facilitate the problem but did not cause it) and focus on his point that the media did not put the problems in our face, I find myself reflecting on a problem.  In a world where traditional press media is dieing (in part because of bloggers who write commentary as a hobby not a job) how do we incentive truth discovery.  Is this (and to what degree) damaging to our democracy? 

The first thing that jumps at me is that market itself.  The players who took credit away from the system in the form of shorting sub-prime mortgages did us a favor by making the problem smaller (although trivially so) than it otherwise would have been (an inverse example of this it that the Internet bubble in equities happened in large part because the shorts were gone…for the moment ignore the circular problem there).  These players were rewarded and in a large way.  The same thing is true of short sellers of the sub prime mortgage companies.  One problem with this path is that these players are demonized not encouraged.  We should think about policy which make shorting or taking a negative view easier not harder (Here’s the tough question: how do we politically insulate this?).

Is this enough?  No, because not everything can be shorted.  Corruption in politics and private fly by night shops are essential ‘private’ enterprise but can’t be sold short; so who cares about information discovery.  There is still a new market for cracking big stories but maybe we should think about policy which enable recover for the investigator.  Your first question might be ‘will this make the NYTimes like a treasure hunter guild?’  Maybe, but would that be bad.  Depends…it is complicated and hard to see how it plays out but it would be an disaster if it made NYTimes into a lawyers hen house.

Rating Agency

After the last year or so it is a wonder that anyone subscribes to rating agencies anymore but they do.  In fact it is headline news when they come out and make tweaks on their outlooks like they did for UK soverign debt on 5/21.  S&P revised its outlook for the UK to negative from stables and affirmed the AAA long term rating and A-1+ short term rating.  This event makes me think about two things.  First (1) The rigidity of the investment community and (2) what do the ratings really mean? 

I’ve complained beforethe ability the rigidity of the investment community but the idea is that if everyone is looking at the same analysis the markets don’t function well because everyone wants to sell at the same time.  This will happen even if it just a descent sized group of people blindly following ‘guidelines’ about ratings, because the smart investors know that non-economic ‘guideline’ sellers will dump securities with a downgrade occurs and thus don’t buy until that flow is well underway.  For those of you who don’t know what I mean by guideline selling it means that a investment manager has a rule about what he can invest in and when that rule is broken he must sell the asset.  This creates a very inelastic (who doesn’t care about price) or what I call ‘non-economic’ seller.  We should be hoping that no one (the big reserve holder or big custodial banks) have a rule about British debt which would disrupt the markets. 

My second question is related to the rating itself.  What is AAA mean?  Low default risk?  If that is the case rating domestic sovereign debt (with a well run finance branch) seems a little odd; worse case it the Bank of England could buy the debt (print the money) and inflation away the debt.  (Yes, I’m ignoring what happen to Russia when they defaulted on their domestic debt but the idea that domestic default seems extremely unlikely is true).  Note: I’m under the impression that AAA for gov’t  and municipals vs corporates are two different scales (you can’t compare across them in a meaningful way only within a group…yes that is annoying).  Does it mean low real purchasing power risk?  If  this where the case then lowering the sovereign debt rating would require the lowering of all other debt (because it would be driven by a macro force: inflation or currency).  So as far as I can tell, AAA mean better than AA, which mean better than A and so on.  Even ignoring the rigidity that the rating agencies put into the system one would hope we (the investment community) could come up with a better (more meaningful) syntax…like probability of default (let use implied and just get rid of the rating agencies).

Distribution of Estimates or Estimates of Distributions

Bernanke should receive the Nobel Peace Prize…what he did for the U.S. economy and there in by the global economy has keep this downturn in hand.  I’m not suggesting that the next great power war would have emerged if he had allowed a deflationary dynamic to gain traction but I find conflict to be feed by the fire of hardship and crisis.  So keep this recession from being a depression is worthy of the prize.  Now why am I saying this.  Honestly, no particularly reason just wanted to put it out there.  Now I’m going to criticise something that I believe he was instrumental in doing: the distributed estimates economic growth by the participants’ at fed meeting.  Here are some of the GDP projection and distribution charts from the minutes release today. 

Ben has for quite some time advocated for transparency (ranging from inflation targeting to new disclosure requirement to the forecast disclosure) with regard to policy making.  In a lot of ways this makes sense (if they have more credability the job become easier, although if they just confuse people with the new information credability is lost).  Now I love the way these chart suggest you should think about the world, that of a distributed or uncertain future.  The idea is we don’t know what the future path of GDP growth will look like but these are our range of guesses and lets work with that range instead of a single estimate (…being a fatalist does make decision making easy though (note: that was a joke)…).  But when I was thinking about these charts I realized that they are really a range of point estimates not a true estimate of the range.  This is a suttle but important difference; I might expect (call this the most likley case) growth in 2011 to be at 4% but if I and everyone else thinks that there is a 25% chance of a L recovery (or 1% growth) in 2011, it will not be captured on this chart even though I suspect it really should be.  This leads the chart to be overly rosy (in that particular example).

Ben – Next time make the chart as an estimate of the distribution instead of distribution of the estimates.

Bank Stress Tests…Missing the Point?

Quick rant…..

Admit it, we don’t really care if a bank or financial institution fails.  What we care about is unemployment and economic growth.  The two things are connected when a bank failure causes a credit collapse (ala Lehman…although that simply accelerated and extentuated a crisis).  Thus was it right to simply stress test the banks?   I want to make the point that it is part but not the whole picture.  Stress testing the banks is a good idea (hard to tell how well it was done).  A regulatory menatility of probabilistic thinking is the right one. 

That being said it is not enough…the Federal Reserve as the monetary authority should be concerned with aggregate credit creation (as that is what is driving the deflation).  The driving force behind the credit contraction is financial market deleveraging.  This is occuring both in the banking sector and the non-bank financial sector.  To put it simply the banks need to be absorb the delevering of the non-bank financial sector (or the fed has to do it…which it has done to a large degree) or a credit collapse will occur.  What does this mean?  We want the banks to have far more capital than they need to survive…like I said up top, we don’t simply care about bank survival.

I was hoping that the stress test would be the rhetoric device to get capital into the system but it doesn’t look like it worked that way (although it does look like banks are raising lots of capital to pay off TARP and if that TARP capital is sent back out into the banking system we might get closer to where we need to be).  I keep coming back to the same idea (not good but the best I’ve got) drown the banking system in capital and don’t let them pay it back until the economy is back on track.  Some argue that this would be expensive, yes but it is cheaper than everything else.  It would be cheaper than a depression and it would be less dangerous (thus cheaper) than having the Federal Reserve doing all of the deleveraging.

Is More Information Better?

My undergraduate thesis was entitled ‘Is More Information Better.”   It was a study of transparency at the Federal Reserve over time.  Looking at it now…the paper made some obvious conceptual errors but in the context of an undergraduate thesis it wasn’t bad.  What made me think about this was a chart I saw in the FT….

The idea is that as the handicapper recieved more ‘information’ they did not become more accurate although they did become more confident.  People are almost always over confident.  I think I read somewhere (although I can’t find it now) that the profession that is least over confident is weathermen…which means if you are constantly told by everyone that you are wrong you may have the right degree of confidence (I think doctors were the worst). 

Another interpretation of this chart is that data is not information.  The handicappers recieved more data but not more information and they were unable to digest that the new data was not useful.  That is how I concluded my thesis…

More information is better but only when it is valuable and relevant.  If increasing the amount of information clouds and confuses the reader as to what the information means that additional information is not valuable.  Thus the FOMC should, as they have been doing, use language very carefully in order to maintaining their own credibility. 

Transparency is not a simple thing and more information is not always better (even when it is clear..although that is a different story).

Deflation or Inflation

If you are an economist you probably have an opinion (quite likley a strong one) on the following question ‘are we in for a period of higher than normal inflation?’   The camps roughly break down into ‘YES!’, ‘NO!’, ‘Yes, but in a year or two’, and the traditional economist response ‘maybe.’  I fall in the maybe, but in a year or two (yes I know I didn’t make that a group).  I think the immediate threat to the US is a deflationary depression but if we come out of this down turn in a year the battle will quickly turn to an inflationary one. 

The inflation camp focuses on the fact that base money (the fed’s balance sheet) has expanded rapidly, the deflation camp focuses on the fact that broad money (banks balance sheets + the shadow banking system) is shrinking.  What matter in the short run is broad money, base money matters more in the medium to long term because it will affect how the broad money grows in the future.  Thus the big unknown is will the Fed, which has been the driving force between base money expansion, be able to unwind the expansion in a meaningful way (meaning unwind it such that broad money doesn’t exploded).  Why does this matter?  We’ll inflation is bad because it distorts the economic price signal and can destabilize the system while deflation is bad because it can cause a shock to debtors (real debts increase) and cause a deflationary depression  (this is what the great depression was).  Ideally 2% inflation seems about right (in normal times) because of the skew in badness (10% deflation is about as bad as 75% inflation).  In my view in an environment of large uncertainty where it is hard to predict how thing will play out that target should be higher, maybe 5%. 

I was playing around looking at two foreign examples.  Japan in the 1990 for deflation and German in the early 1920s for inflation.  Now both of these situation are complex and I am NOT saying that these are the paths we will travel (Germany was printing money to finance the government not run monetary policy and note the militarization of the economy and WWII in the late 1930s; Japan did not respond to deflationary pressure but was held up through export growth) but it is interesting to see the picture of how economic growth developed.

I read the chart in the following way.  Large scale inflation can cause a collapse in economic activity but the economy will right itself more quickly then a deflation downturn while a deflation down turn is slower (although it can be big - look at 29-32 for Germany).  This makes some sense to me in that both will cause a systematic default, deflation defaults through legal (lawyers and courts) default while inflation defaults through real losses to the creditors (as the value of their nominal debts decreases); everything takes longer when lawyers are involved.

Dollar Trap

A somewhat popular topic of late is the ‘dollar trap’that China is in.  The short story is that China has held down their currency in order maintain domestic stability (the connection is lower exchange rate means a more competitive export sector which means faster economic growth which means increased domestic stability).  The price for holding down the currency is that they have to buy dollars at an overvalued price.  They have been doing this for years and have a accumulated a large  quantity of dollar assets (let’s say 1.5 trillon).  That means relatively small changes in the dollar exchange rate will cause large losses (which in the context of a slowing economy may inspire domestic strife…remember goal number one is domestic stability).  If they stop buying dollars the RMB will appreciate against the dollar and they will lose competitiveness and exports growth will slow (it has collapsed of late due to the down turn; remember you can be the most competitive but in a shrinking market you’ll still lose sales) but if you continue to buy dollar this rope around your neck will tighten (What I mean by the rope tightening is that (1) if you buy the dollars with unsterilized RMB inflation will occur (eventually) which is very destabilizing, (2) if you buy the dollars with sterilized RMB you have to fund it with debt which will eventually cause an asset liability mismatch which will bankrupt the government, or (3) if you sterilize the transaction with surplus receipts you’ll impoverish the people (destabilizing) negating the point of economic growth. 

Zhou Xiaochuancame out with a proposal to allow the PBOC to exchange their dollar at the IMF for SDR (a diversified currency basket), this would only change the trap from a dollar trap to a global currency trap and move some of the dollar risk on the IMF.  I’m also skeptical of the idea of the SDR replacing the Dollar as the world reserve currency (I won’t go tangent with this topic as that not what I’m trying to get at).  I would be very surprised if this were to happen. 

The economist has an article on this topic and a response came from Fred Bergsten at the Peterson Institute for International Economic which I found very odd. 

SIR – The punchline to your article on China’s foreign-exchange reserves is that “China cannot sour on the dollar without letting its own currency rise” (Economics focus, April 25th). This is not correct. China can continue to hold down the yuan’s exchange rate by buying dollars but then convert those dollars into euros or other hard currencies. The exchange rate between the dollar and the euro would change but the yuan would remain substantially undervalued.

Maybe I’m missing something but he seems to suggest that one could influence the FX markets but routing your trades through a middle currency.  This doesn’t strike me as right.  It doesn’t matter what currency is the transaction currency or the middle man currency but rather the final demand (the ‘final’ resting place) of the value.  His statement seems to suggest that when the market has dollars sold into it and the euro bought from the market that they are stuck with those assets.  The traders will look across all the pair and see where they can get the best deal for the dollar they bought with the euros…the ‘final’ resting place will determine value.  Thus if China want to ensure a cheap RMB vs the dollar they must store the value in dollars. 

He also suggest that the SDR swap would be a means to convert the portfolio without taking exchange rate risk; this strikes me as missing the point.  We could do a swap that would get China out of this position but that would ignore the imbalances that they have fueled and encourage others to do the same.  (And no one is going to want to take the other side of that swap).  Like I noted above the SDR swap would convert the dollar trap into a global developed currency trap (or anything else that we want to swap it to) which would not resolve the underlying issue that the RMB is undervalued and would only allow the imbalance to continue. 

The problem is imbalances and the cost to Chinese is excess dollar accumulation….they can’t escape those cost but hopefully the more obvious the risk become the more willing they will be to help resolve the imbalances. 

Negotiations or Stress Test?

The Stress came out last week and before I went through any numbers my knee-jerk response was the numbers (capital to be raised) looked small.  I like the approach (of simulation and forward looking stress test) but wonder how well it worked. 

A few comments…First off its not clear to me what type of regulatory authority the Fed/Treasury has to force banks to raise capital if they are, according to the existing rules, above thier capital requirements.  Apparently some banks considered suing to say that they didn’t need to raise the capital.  Second the stress test simple underlying assumptions which I discussed (complained about) before were a little off – particularly unemployment.  Now being wrong about something that is difficult to predict isn’t a crime (or shouldn’t be – often treated like it is) but continuing to do something incorrectly when you know that it is incorrect  is a crime (and should be treated as such (not jail but fired)).  This stupidity happens for a number of reasons such as status quo bias (the way it is done), what I call rule bias (but the rule says), what I call defered responsibility bias (but so and so said) and other reasons (including being lazy).  Nothing excuses you for being stupid (doing something the wrong way when you know it is wrong is stupid).  Now I suspect (should say hope) they updated thier projections as they went as to incorporate new information. 

 

 

Third the WSJ has an article about how the number where essentially negoitated (make me wonder if Simon Johnson is right about a Wall Street -Washington connection…I don’t think he is) down and how banks will be able to ‘earn’ the capital instead of raising it before the deadline.  I don’t like eithier of these things.  It should not be a negotiation (although the banks can provide thier opinion) but it may have become one because of the authority issue (see point one).  But more importantly the skew of these events is such that an error on the under capitalized side is a disator (deflation depression) while an error on the over capitalized side (ignoring possible non linear political problems) is a ‘bad’ return for tax payers (although the losses from a deflationary depression would be much much worse).  Also we need a well capitalized banking system now (not in 6 months while they earn the capital).   Lowering the estimates didn’t strike me as smart. 

I’ve been of the opinon that it make sense to drown the banks in capital (tell them take this massive amounts of perferred and common equity and you can pay it back when the economy is growing at an above average rates…this would make them use the capital instead of treating it like a short term loan (which defeats the point).  Admitedly there are complication to this approach as well….

Those who are right are wrong

People like things that are clear, ‘If you are right, you are right and if you are wrong your wrong.’  The rhetoric is less true than we would like to admit.  We give too much credit to people who get ‘it right’ and harp on people too much that get ‘it wrong.’  Honestly I don’t think anyone predicted the collapse of the financial infrastructure that has happened over the past year and those who where close – albeit wise and insightful – also were off base.  In that the truth was what happened was one possible outcome (the one that happened) but it did not have to happen that way.  If we hadn’t let Lehman fail, if agency lending had not be curtailed, if we didn’t rescue the agencies by hammering the preferred (owned by small banks throughout the country) the deleveraging that was going on may have continued in a some what orderly way and not in the crash and burn method that happened.  I was thinking about this after reading Brad Setser’s blog post last week about selective interpretations of risk theory and how that lead to a weak system.  I agree with the basic point but when I was reading it I got the feeling as if somehow what happened was an inevitability and thus proving without a doubt that the prior risk taking was foolish; which I don’t think is true.  Put another way, if you never fail/collapse/miss the flight your not pushing your self hard enough/not taking enough risk/leaving to early.  So failing – albeit bad – is not proof (although it is evidence) that something is wrong.  My point is that just as you should consider a probabilistic future when considering decisions; when evaluating past decisions (and don’t get me wrong mistakes were made) you need to evaluate them in the context of probabilistic outcome not simply what happened. 

Consider the following extreme example.  Imagine you saw the following: person A offer person B 100 dollars to play Russian roulette with six shooter (with one bullet), and person B took the offer and ‘won’ (didn’t die) and was paid the 100 dollars.  You would say to person B, ‘That was stupid.  Why did you do that?’  If they responded ‘look at the evidence, I was right’  and then walked away.  You’d would not think to yourself that the person had made a good decision (had been right) but that they were crazy.  They were ‘right’ but clearly wrong.

Bank Stress Test: Transparency is Hard

I commend transparency when it is appropriate (note: it is not always – particularly when it simply confuses the users or is abused by the political system…read ‘where the costs are greater than the benefit’).  That being said – for the most part – the bank stress test has been fairly transparent – in a good way – releasing methodology and sending out details about the logic (even if you don’t agree with the degree of stress, you likley agree the disclosures have been nice…although everyone would have back out what they did afterward so this was the smart way to do it).  So I feel a little mean in what I’m going to say next because it seems like they are trying so hard but the fist chart in the stress test results is obnoxiously deceiving.  The chart show the stress test total loan loss rate over two years against the loan loss rate over two years going back to 1921. 

You may look at this and say, ‘good, the banks are well capitalized enough to survive even the Great Depression.’  Wrong (assuming I’m reading the chart right).  The red line is the stressed level which if that occur the banks will be right on the edge of thier capital constraints (not a comfortable place to be…read ‘failed’).  For the banks to survive the blue line going up to the red line it would have to retreat to a typical level of 1-2% instantly or they would go bust (the blue lines doesn’t move like that, its smoother..the Great Depression was more than 2 years).  Its the accumulation of losses in excess of earning that hack away at capital, not a two-year rolling window, that matter.  This presentation suggest that the Fed and Treasury are assuming we are out of this  (and back to normal) by 2011; that seems a little optomistic in the default areana (like I said…the blue line doesn’t move like that).  Its worth noting that banks are making good money on large spread so they may be able to handle a 2+ default rate without having the capital base eatten away at (and getting paid interest on reserve)

I would have like to see the presentation done as capital drawdown or capital base growth given historical loan default back to 1921 which would need to include bank earning and not be a two year rolling window.  That being said this forward looking (fix the banking/financial system) plan is the right way to go; hopefully we have enough capital in the system to make it work (and the populist rhetoric doesn’t screw it up….if it hasn’t already….we don’t want them to pay the money back).